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AJG > SEC Filings for AJG > Form 10-Q on 24-Apr-2014All Recent SEC Filings

Show all filings for GALLAGHER ARTHUR J & CO

Form 10-Q for GALLAGHER ARTHUR J & CO


24-Apr-2014

Quarterly Report


Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations

The discussion and analysis that follows relates to our financial condition and results of operations for the three-month period ended March 31, 2014. Readers should review this information in conjunction with the unaudited consolidated financial statements and notes included in Item 1 of Part I of this quarterly report on Form 10-Q and the audited consolidated financial statements and notes, and Management's Discussion and Analysis of Financial Condition and Results of Operations, contained in our annual report on Form 10-K for the year ending December 31, 2013.

Information Concerning Forward-Looking Statements

This report contains certain statements related to future results, or states our intentions, beliefs and expectations or predictions for the future, which are forward-looking statements as that term is defined in the Private Securities Litigation Reform Act of 1995. Forward-looking statements relate to expectations or forecasts of future events. Such statements use words such as "anticipate," "believe," "estimate," "expect," "contemplate," "forecast," "project," "intend," "plan," "potential," and other similar terms, and future or conditional tense verbs like "could," "may," "might," "see," "should," "will" and "would." You can also identify forward-looking statements by the fact that they do not relate strictly to historical or current facts. For example, we may use forward-looking statements when addressing topics such as: market and industry conditions, including competitive and pricing trends; acquisition strategy; the expected impact of acquisitions and dispositions; the development and performance of our services and products; changes in the composition or level of our revenues or earnings; our cost structure and the outcome of cost-saving or restructuring initiatives; the outcome of contingencies; dividend policy; pension obligations; cash flow and liquidity; capital structure and financial losses; future actions by regulators; the impact of changes in accounting rules; financial markets; interest rates; foreign exchange rates; matters relating to our operations; income taxes; expectations regarding our investments, including our clean energy investments; and closing the Wesfarmers insurance brokerage acquisition and integrating such business. These forward-looking statements are subject to certain risks and uncertainties that could cause actual results to differ materially from either historical or anticipated results depending on a variety of factors.

Many factors could affect our actual results, and variances from our current expectations regarding such factors could cause actual results to differ materially from those expressed in our forward-looking statements. Potential factors that could impact results include:

Volatility or declines in premiums or other adverse trends in the insurance industry;

An economic downturn, including one caused by the U.S. government shutdown and potential default, as well as uncertainty regarding the European debt crisis and market perceptions concerning the instability of the Euro;

Competitive pressures in each of our businesses;

Risks that could negatively affect the success of our acquisition strategy, including continuing consolidation in our industry and growing interest in acquiring insurance brokers on the part of private equity firms, which could make it more difficult to identify targets and could make them more expensive, execution risks, integration risks, the risk of post-acquisition deterioration leading to intangible asset impairment charges, and the risk we could incur or assume unanticipated regulatory liabilities such as those relating to violations of anti-corruption and sanctions laws;

Our failure to attract and retain experienced and qualified personnel;

Risks arising from our growing international operations, including the risks posed by political and economic uncertainty in certain countries, risks related to maintaining regulatory and legal compliance across multiple jurisdictions (such as those relating to violations of anti-corruption, sanctions and privacy laws), and risks arising from the complexity of managing businesses across different time zones, geographies, cultures and legal regimes;

Risks particular to our risk management segment;

The lower level of predictability inherent in contingent and supplemental commissions versus standard commissions;

Sustained increases in the cost of employee benefits;

Our failure to apply technology effectively in driving value for our clients through technology-based solutions, or failure to gain internal efficiencies and effective internal controls through the application of technology and related tools;

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Our inability to recover successfully should we experience a disaster, material cybersecurity attack or other significant disruption to business continuity;

Our failure to comply with regulatory requirements, including those related to international sanctions, or a change in regulations or enforcement policies that adversely affects our operations;

Violations or alleged violations of the U.S. Foreign Corrupt Practices Act (FCPA), the U.K. Bribery Act 2010 (U.K. Bribery Act) or other anti-corruption laws;

Our failure to adapt our services to changes resulting from the Patient Protection and Affordable Care Act and the Health Care and Education Affordability Reconciliation Act (2010 Health Care Reform Legislation);

Unfavorable determinations related to contingencies and legal proceedings;

Damage to our reputation if clients are not satisfied with our services;

Improper disclosure of personal data;

Significant changes in foreign exchange rates;

Changes in our accounting estimates and assumptions;

Risks related to our clean energy investments, including the risk of environmental and product liability claims and environmental compliance costs;

Disallowance of Internal Revenue Code of 1986, as amended, (which we refer to as IRC) Section 29 or IRC Section 45 tax credits;

Risks related to losses on other investments held by our corporate segment;

Restrictions and limitations in the agreements and instruments governing our debt;

The risk of share ownership dilution when we issue common stock as consideration for acquisitions;

Volatility of the price of our common stock;

Failure to successfully integrate the Wesfarmers insurance brokerage business and operations or fully realize synergies from such acquisition in the expected time frame; and

Share sale agreement for the Wesfarmers acquisition may be terminated in accordance with its terms and such acquisition may not be completed.

Accordingly, you should not place undue reliance on forward-looking statements, which speak only as of, and are based on information available to us on, the date of the applicable document. All subsequent written and oral forward-looking statements attributable to us or any person acting on our behalf are expressly qualified in their entirety by the cautionary statements contained or referred to in this section. We do not undertake any obligation to update any such statements or release publicly any revisions to these forward-looking statements to reflect events or circumstances after the date of this report or to reflect the occurrence of unanticipated events.

Forward-looking statements are not guarantees of future performance. They involve risks, uncertainties and assumptions, including the risk factors referred to above. Our future performance and actual results may differ materially from those expressed in forward-looking statements. Many of the factors that will determine these results are beyond our ability to control or predict. Forward-looking statements speak only as of the date that they are made, and we undertake no obligation to publicly update or revise any forward-looking statements, whether as a result of new information, future events or otherwise.

A detailed discussion of the factors that could cause actual results to differ materially from our published expectations is contained under the heading "Risk Factors" in our filings with the Securities and Exchange Commission, or the SEC, including this report, our Annual Report on Form 10-K for the fiscal year ended December 31, 2013 and any reports we file with the SEC in the future.

Information Regarding Non-GAAP Measures and Other

In the discussion and analysis of our results of operations that follows, in addition to reporting financial results in accordance with GAAP, we provide information regarding EBITDAC, EBITDAC margin, adjusted EBITDAC, adjusted EBITDAC margin, diluted net earnings per share (as adjusted) for the brokerage and risk management segments, adjusted revenues, adjusted compensation and operating expenses, adjusted compensation expense ratio, adjusted operating expense ratio and organic revenue measures for each operating segment. These measures are not in accordance with, or an alternative to, the GAAP information provided in this quarterly report on Form 10-Q. We

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believe that these presentations provide useful information to management, analysts and investors regarding financial and business trends relating to our results of operations and financial condition. Our industry peers may provide similar supplemental non-GAAP information related to organic revenues and EBITDAC, although they may not use the same or comparable terminology and may not make identical adjustments. The non-GAAP information we provide should be used in addition to, but not as a substitute for, the GAAP information provided. Certain reclassifications have been made to the prior-year amounts reported in this quarterly report on Form 10-Q in order to conform them to the current-year presentation.

Adjusted presentation - We believe that the adjusted presentations of the current and prior year information presented on the following pages provides stockholders and other interested persons with useful information regarding certain of our financial metrics that will assist such persons in analyzing our operating results as they develop a future earnings outlook for us. The after-tax amounts related to the adjustments were computed using the normalized effective tax rate for each respective period.

Adjusted revenues and expenses - We define these measures as revenues, compensation expense and operating expense, respectively, each adjusted to exclude gains realized from sales of books of business, acquisition integration costs, New Zealand earthquake claims administration, South Australia and claim portfolio transfer ramp up fees/costs, workforce related charges, lease termination related charges, acquisition related adjustments and the impact of foreign currency translation, as applicable. Integration costs include costs related to transactions not expected to occur on an ongoing basis in the future once we fully assimilate the applicable acquisition. These costs are typically associated with redundant workforce, extra lease space, duplicate services and external costs incurred to assimilate the acquisition with our IT related systems.

Adjusted ratios - Adjusted compensation expense ratio and operating expense ratio are defined as adjusted compensation expense and adjusted operating expense, respectively, each divided by adjusted revenues.

Earnings Measures - We believe that the presentation of EBITDAC, EBITDAC margin, adjusted EBITDAC, adjusted EBITDAC margin and diluted net earnings per share (as adjusted) for the brokerage and risk management segments, each as defined below, provides a meaningful representation of our operating performance. We consider EBITDAC and EBITDAC margin as a way to measure financial performance on an ongoing basis. Adjusted EBITDAC, adjusted EBITDAC margin and diluted net earnings per share (as adjusted) for the brokerage and risk management segments are presented to improve the comparability of our results between periods by eliminating the impact of the items that have a high degree of variability.

EBITDAC - We define this measure as net earnings before interest, income taxes, depreciation, amortization and the change in estimated acquisition earnout payables.

EBITDAC margin - We define this measure as EBITDAC divided by total revenues.

Adjusted EBITDAC - We define this measure as EBITDAC adjusted to exclude gains realized from sales of books of business, acquisition integration costs, workforce related charges, lease termination related charges, New Zealand earthquake claims administration, South Australia and claim portfolio transfer ramp up fees/costs, acquisition related adjustments, and the period-over-period impact of foreign currency translation, as applicable.

Adjusted EBITDAC margin - We define this measure as adjusted EBITDAC divided by total adjusted revenues (defined above).

Diluted net earnings per share (as adjusted) - We define this measure as net earnings adjusted to exclude the after-tax impact of gains realized from sales of books of business, acquisition integration costs, New Zealand earthquake claims administration, South Australia and claim portfolio transfer ramp up fees/costs, workforce related charges, lease termination related charges and acquisition related adjustments, the period-over-period impact of foreign currency translation, as applicable, divided by diluted weighted average shares outstanding.

Organic Revenues - For the brokerage segment, organic change in base commission and fee revenues excludes the first twelve months of net commission and fee revenues generated from acquisitions accounted for as purchases and the net commission and fee revenues related to operations disposed of in each year presented. These commissions and fees are excluded from organic revenues in order to help interested persons analyze the revenue growth associated with the operations that were a part of our business in both the current and prior year. In addition, change in organic growth excludes the impact of supplemental and contingent commission revenues and the period-over-period impact of foreign currency translation. The amounts excluded with respect to foreign currency translation are calculated by applying current year foreign exchange rates to the same prior year periods. For the risk

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management segment, organic change in fee revenues excludes the first twelve months of fee revenues generated from acquisitions accounted for as purchases and the fee revenues related to operations disposed of in each year presented. In addition, change in organic growth excludes the impact of South Australia ramp up fees, New Zealand earthquake claims administration and the period-over-period impact of foreign currency translation to improve the comparability of our results between periods by eliminating the impact of the items that have a high degree of variability or are due to the limited-time nature of these revenue sources.

These revenue items are excluded from organic revenues in order to determine a comparable measurement of revenue growth that is associated with the revenue sources that are expected to continue in the current year and beyond. We have historically viewed organic revenue growth as an important indicator when assessing and evaluating the performance of our brokerage and risk management segments. We also believe that using this measure allows readers of our financial statements to measure, analyze and compare the growth from our brokerage and risk management segments in a meaningful and consistent manner.

Reconciliation of Non-GAAP Information Presented to GAAP Measures - This quarterly report on Form 10-Q includes tabular reconciliations to the most comparable GAAP measures for adjusted revenues, adjusted compensation expense and adjusted operating expense, EBITDAC, EBITDAC margin, adjusted EBITDAC, adjusted EBITDAC margin, diluted net earnings per share (as adjusted) and organic revenue measures.

Other Information - Allocations of investment income and certain expenses are based on reasonable assumptions and estimates primarily using revenue, headcount and other information. We allocate the provision for income taxes to the brokerage and risk management segments using local country statutory rates. As a result, the provision for income taxes for the corporate segment reflects the entire benefit to us of the IRC Section 45 credits generated, because that is the segment which produced the credits. The law that provides for IRC Section 45 credits substantially expires in December 2019 for our fourteen 2009 Era Plants and in December 2021 for our twenty 2011 Era Plants. We anticipate reporting an effective tax rate of approximately 35.0% to 37.0% in both our brokerage and risk management segments for the foreseeable future. Reported operating results by segment would change if different allocation methods were applied.

In the discussion that follows regarding our results of operations, we also provide the following ratios with respect to our operating results: pretax profit margin, compensation expense ratio and operating expense ratio. Pretax profit margin represents pretax earnings divided by total revenues. The compensation expense ratio is compensation expense divided by total revenues. The operating expense ratio is operating expense divided by total revenues.

Overview and First Quarter 2014 Highlights

We are engaged in providing insurance brokerage and third-party property/casualty claims settlement and administration services to entities in the U.S. and abroad. Throughout 2013 and into 2014, we have expanded and expect to continue to expand our international operations through both acquisitions and organic growth. We generate approximately 75% of our revenues for the combined brokerage and risk management segments domestically, with the remaining 25% derived internationally, primarily in Australia, Bermuda, Canada, the Caribbean, Singapore, New Zealand and the U.K. (based on first quarter 2014 revenues). We expect that our international revenue will continue to grow as a percentage of our total revenues in 2014 compared to 2013, given the number and size of the non-U.S. acquisitions that we made in the latter part of 2013 and in 2014 (as well as the anticipated Wesfarmers transaction described below). We have three reportable segments: brokerage, risk management and corporate, which contributed approximately 62%, 17% and 21%, respectively, to revenues during the three-month period ended March 31, 2014. Our major sources of operating revenues are commissions, fees and supplemental and contingent commissions from brokerage operations and fees from risk management operations. Investment income is generated from our investment portfolio, which includes invested cash and fiduciary funds, as well as clean energy and other investments.

We have generated positive organic growth in each of the last thirteen quarterly periods in both the brokerage and risk management segments. Based on our experience, we believe we are seeing continued evidence of moderate rate increases and our customers are increasingly optimistic about their business prospects. The first quarter 2014 Council of Insurance Agents and Brokers (which we refer to as CIAB) survey had not been published as of the filing date of this report, but we anticipate that the trends evident in the fourth quarter 2013 survey continued into the first quarter 2014. The fourth quarter 2013 CIAB survey indicated that rates were up, on average 2.1% across all sized accounts, which was down from the 3.4% reported for the third quarter 2013 survey. The fourth quarter 2013 survey indicated that the 2013 year ended with a slight slowdown of commercial property/casualty pricing increases, which indicates that the overall firming market appears to have moderated during the second half of 2013 and this trend could continue into 2014. The CIAB represents the leading domestic and international insurance brokers, who write approximately 80% of the commercial property/casualty premiums in the U.S.

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Our operating results improved in first quarter 2014 compared to the same period in 2013 in both our brokerage and risk management segments:

In our brokerage segment, total revenues and adjusted total revenues were both up 25% and 24%, respectively, base organic commission and fee revenues were up 3.3%, net earnings were up 33%, adjusted EBITDAC was up 34% and adjusted EBITDAC margins were up 150 basis points.

In our risk management segment, total revenues and adjusted total revenues were up 4% and 7%, respectively, organic fees were up 6.0%, net earnings were down 13%, adjusted EBITDAC was up 8% and adjusted EBITDAC margins were up 10 basis points.

In our combined brokerage and risk management segments, total revenues and adjusted total revenues were both up 20%, organic commissions and fee revenues were up 4.0%, net earnings were up 16%, adjusted EBITDAC was up 28% and adjusted EBITDAC margins were up by 120 basis points.

Our acquisition program and our integration efforts are on track. During the first quarter of 2014, the brokerage segment completed nine acquisitions with annualized revenues totaling $17.8 million.

In our corporate segment, earnings from our clean energy investments contributed $20.9 million to net earnings in the first quarter of 2014, which included a non-cash after-tax gain of $14.1 million. On March 1, 2014, we acquired additional ownership interests in seven of the 2009 Era Plants and five of the 2011 Era Plants from a co-investor. All but one of our investments in these plants had been accounted for under the equity method of accounting. For all plants where our ownership is now over 50%, as of March 1, 2014 we consolidated the operations of the limited liability companies that own these plants. The transaction resulted in the non-cash after-tax gain of $14.1 million, which resulted from a provisional estimate of fair value as of the transaction date. We anticipate our clean energy investments to generate between $90.0 million and $100.0 million to net earnings in 2014. We expect to use these additional earnings to continue our mergers and acquisition strategy in our core brokerage and risk management operations.

On April 1, 2014, we signed and closed on an agreement to acquire the Oval Group of Companies (which we refer to as Oval). Under the agreement, we agreed to purchase all of the outstanding equity of Oval for net cash consideration of approximately $331.0 million, which includes approximately $3.5 million held back and placed into escrow for three years as partial security for warranty obligations under the agreement and approximately $8.3 million held back and placed into escrow for approximately three months as partial security for adjustments to the balance sheet. Oval is a commercial insurance broker operating out of 24 offices throughout the U.K., with over 1,000 employees. Oval is expected to annually generate over $135.0 million in revenues.

On April 6, 2014, we signed an agreement to acquire the Wesfarmers Insurance Brokerage operations (which we refer to as the Wesfarmers transaction). The Wesfarmers transaction, which includes the OAMPS businesses in Australia and the U.K., Crombie Lockwood in New Zealand and the associated premium funding operations, is subject to regulatory approval and is expected to close during the second or third quarter of 2014. Under the agreement, we agreed to purchase all of the outstanding shares of three operating companies for net cash consideration of approximately $933.0 million. The Wesfarmers Insurance Brokerage operations generated $306.0 million in revenue for the year ended June 30, 2013 and have approximately 1,700 employees operating out of more than 50 offices across Australia, New Zealand and the U.K. We expect to finance the Wesfarmers transaction using free cash, borrowing on our line of credit and proceeds from our previously described secondary offering of 21.85 million shares of our common stock. We also entered into a A$400.0 million foreign currency derivative investment contract that we executed on April 16, 2014 in connection with the signing of the agreement to acquire the Wesfarmers Insurance Brokerage operations. The derivative investment contract will expire by June 16, 2014.

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The following provides non-GAAP information that management believes is helpful when comparing revenues, EBITDAC and diluted net earnings per share for the three-month period ended March 31, 2014 with the same period in 2013:

For the Three-Month Periods

Ended March 31,                                                                                                Diluted Net Earnings
                                             Revenues                            EBITDAC                            Per Share
Segment                             2014        2013        Chg        2014         2013        Chg        2014         2013        Chg
                                           (in millions)                      (in millions)
Brokerage, as adjusted             $ 567.6     $ 457.0        24 %    $ 110.7      $  82.4        34 %    $  0.29      $  0.22        32 %
Net gains on book sales                1.0         0.4                    1.0          0.4                     -            -
Acquisition integration                 -           -                    (6.5 )       (3.0 )                (0.03 )      (0.02 )
Workforce & lease termination           -           -                    (2.2 )         -                   (0.01 )         -
Acquisition related adjustments         -           -                    (1.1 )         -                   (0.01 )      (0.01 )
Levelized foreign currency
translation                             -         (3.0 )                   -           0.5                     -            -

Brokerage, as reported               568.6       454.4                  101.9         80.3                   0.24         0.19

Risk Management, as adjusted         160.0       148.9         7 %       26.0         24.1         8 %       0.10         0.10         0 %
Workforce & lease termination           -           -                    (0.2 )         -                      -            -
South Australia and claim
portfolio transfer ramp up              -          1.4                   (1.2 )        1.3                  (0.01 )       0.01
Levelized foreign currency
translation                             -          3.3                     -           1.1                     -            -

Risk Management, as reported         160.0       153.6                   24.6         26.5                   0.09         0.11

Total Brokerage & Risk
Management, as reported              728.6       608.0                  126.5        106.8                   0.33         0.30
Corporate, as reported               186.4        66.1                   (6.0 )       (8.5 )                 0.03         0.02

Total Company, as reported         $ 915.0     $ 674.1                $ 120.5      $  98.3                $  0.36      $  0.32

Total Brokerage & Risk
Management, as adjusted            $ 727.6     $ 605.9        20 %    $ 136.7      $ 106.5        28 %    $  0.39      $  0.32        22 %

Results of Operations

Brokerage

The brokerage segment accounted for 62% of our revenues during the three-month . . .

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