Arthur J. Gallagher & Co. (NYSE:AJG) Q4 2022 Earnings Call Transcript

Arthur J. Gallagher & Co. (NYSE:AJG) Q4 2022 Earnings Call Transcript January 26, 2023

Arthur J. Gallagher & Co. misses on earnings expectations. Reported EPS is $1.3 EPS, expectations were $1.5.

Operator: Good afternoon, and welcome to Arthur J. Gallagher & Company’s Fourth Quarter 2022 Earnings Conference Call. .Today’s call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions may constitute forward-looking statements within the meaning of the securities laws. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the cautionary statement and risk factors contained in the company’s 10-K, 10-Q and 8-K filings for more details on its forward-looking 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 earnings release and other materials in the Investor Relations section of the company’s website.

It is now my pleasure to introduce Patrick Gallagher, Chairman, President and CEO, Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.

Patrick Gallagher: Thank you. Good afternoon, and thank you for joining us for our fourth quarter ’22 earnings call. On the call with me today is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. We had a terrific finish to cap off an excellent year. During the quarter, for our combined Brokerage and Risk Management segments, we posted 16% growth in revenue, 11.7% organic growth. GAAP earnings per share of $0.83, adjusted earnings per share of $1.86, up 24% year-over-year, reported net earnings margin of 9%, adjusted EBITDAC margin of 29.6%, up 120 basis points. We also completed 17 mergers totaling more than $140 million of estimated annualized revenues in addition to announcing our agreement to acquire Buck, another fantastic quarter by the team and our best fourth quarter in decades.

Let me give you some more detail on our fourth quarter performance, starting with our Brokerage segment. Reported revenue growth was 16%. Organic was 11%. Doug will explain it does include a point from our Annual 606 review, Brokerage organic and double digits is outstanding. Acquisition rollover revenues were $107 million, and our adjusted EBITDAC margin was 31.3%, up 120 basis points and in line with our December IR Day expectations, another excellent quarter for the brokerage team. Focusing on the Brokerage segment organic, let me walk you around the world and provide some more detailed commentary starting with our P/C operations. Our U.S. retail business posted 8% organic, our new business was a bit better than last year offset somewhat by less nonrecurring business, client retention and the combined impact of rate and exposure were both similar to last year’s fourth quarter.

Risk Placement Services, our U.S. wholesale operations, posted organic above 9%. This includes more than 12% organic and open brokerage and about 7% organic in our MGA programs and binding businesses. New business was strong and retention was consistent with last year’s fourth quarter. Shifting to outside the U.S. Our U.K. businesses, both retail and specialty combined posted organic of 17% benefiting from excellent new business production, strong retention and the continued impact of renewal premium increases. Australia and New Zealand combined, organic was 12%. Net new versus loss business was consistent with last year and renewal premium increases were above fourth quarter ’21 levels. Canada was up nearly 9% organically, reflecting solid new business and retention.

Moving to our employee benefit brokerage and consulting business. Organic was 3%, consistent with our December IR Day expectations. New business was similar to last year’s fourth quarter and retention remained excellent. And finally, to reinsurance. Our legacy reinsurance operations crushed it with some hard earned new business wins and quarterly organic well into double digits. And recall that December was the first month our newly acquired reinsurance operations were included in organic. And while off a very small revenue base, they too had a spectacular organic growth for the month. So combined, Gallagher Re team continues to deliver outstanding results. So again, Brokerage segment, all in organic double digits. And with our outstanding fourth quarter finish, full year organic came in at 9.7%.

That’s our best full year Brokerage segment organic performance in decades and even more impressive when you consider we grew on top of the 8% organic we posted in ’21. Next, let me give you some thoughts on the current P/C market environment starting in the primary insurance market. Overall, global fourth quarter renewal premiums, that’s both rate and exposure combined, were up more than 9% that’s consistent with the 8% to 10% renewal premium change we have been reporting throughout ’22. Fourth quarter renewal premium changes by line of business were broadly consistent with the first 3 quarters of ’22 with 1 exception, which is D&O. D&O continues to be the one area where rates are flat to down slightly, but in some cases, our customers are using the weaker pricing to purchase more limit.

Exposures also continue to be consistent with the first 3 quarters of ’22, indicating continued strength in our customers’ business activity. In fact, fourth quarter midterm policy endorsements, audits and cancellations were better than fourth quarter ’21 levels. Looking ahead, these trends appear to be holding. Thus far in January, midterm policy endorsements and audit adjustments are trending higher than last year’s level and global renewal premium increases are consistent with the fourth quarter. But remember, our job is to help clients mitigate premium increases and provide an appropriate level of risk transfer that fits their budgets. Shifting to reinsurance and the important January 1 renewals. As we discussed in our 1st View Market report published earlier this month, it was a very late and complex reinsurance renewal season.

Not surprising, U.S. peak zone property cat reinsurance saw some of the largest price increases. But it’s worth noting 4 additional trends within property cat: First, attachment points were raised broadly; second, reinsurers pushed to remove prepaid reinstatements from some contracts; third, reinsurers, in some cases, were able to reduce coverage to named perils only; and fourth, top layers of many programs saw the largest percentage increases as reinsurers sought to push up minimum premium rates. On the casualty side, prices were up in the single to low double-digit range for most programs, while terms and conditions were more stable. Despite the tough market backdrop of higher prices, lower capacity and tightening terms, the reinsurance team was able to deliver favorable outcomes for our clients.

Looking forward, the challenging reinsurance market conditions will, no doubt, put pricing pressure on the primary market during ’23, and that’s on top of our primary carrier partners dealing with catastrophe losses in secondary perils, including convective storms, floods and wildfires, high replacement cost inflation from raw materials to shortages in labor, social inflation, combined with the easing of the judicial system law , escalating medical cost trends and ongoing geopolitical tensions. So there’s good reason to expect continued price increases and cautious underwriting for the foreseeable future. And as I mentioned before, we are not seeing any signs of exposure contraction. Rather, it seems our clients’ business activity remains unchanged from the past few quarters.

Within our employee benefit brokerage and consulting business, the backdrop for ’23 is also broadly favorable. Employers continue to add jobs and wages are growing. So demand for our services and offerings should remain robust. So as I sit here today, ’23 could be another fantastic year with brokerage organic growth nicely in the 7% to 9% range. Moving on to mergers and acquisitions. We had a really active fourth quarter completing 17 new tuck-in brokerage mergers representing more than $140 million of estimated annual revenues. I’d like to thank all of our new partners for joining us and extend a very warm welcome to our growing Gallagher family of professionals. For the year, we completed 36 mergers, representing annualized revenue of about $250 million.

Additionally, we announced an agreement to acquire Buck, a very complementary business providing retirement, HR and employee benefits consulting and administrative services with estimated annualized revenues of $280 million. We expect the transaction to close during the second quarter and look forward to welcoming our new colleagues. Moving to our merger and acquisition pipeline. We have nearly 45 term sheets signed or being prepared, representing more than $300 million of annualized revenue. We know not all of these will close. However, we believe we will get our fair share. And before I conclude my M&A comments, let me give you a quick recap on our reinsurance acquisition now that we have a full year in our books. We had a fantastic ’22, thanks to strong client retention, the expansion of existing client relationships, some great new business wins and excellent growth in our pro rata business.

The team is fully assimilated, is delivering for clients and there’s a lot of momentum. I believe we’re on track for an even better ’23. Needless to say, reinsurance continues to be an exciting story. Moving on to our Risk Management segment, Gallagher Bassett. Fourth quarter organic growth was 15.6% as a strong finish to the quarter pushed organic above our mid-December expectation. Core new arising claims increased during the quarter, driven by recent new business wins and continued growth from existing clients. And fourth quarter adjusted EBITDAC margin was great at 19.3%. So putting it all together, Gallagher Bassett finished the year with an adjusted EBITDAC margin of 18.5% and 13.3% organic benefiting from increased claim activity coming out of the pandemic and some really nice new business wins.

Looking forward, full year ’23 organic should be pushing 10% and adjusted EBITDAC margins should be around 19%. That would be another fantastic year. And I’d like to conclude with some comments regarding our bedrock culture. It’s a culture of teamwork, client service and excellence, captured and celebrated in the Gallagher way. It is the culture that drove full year ’22 results for our combined Brokerage and Risk Management segments of 24% growth in adjusted revenues, 10% all-in organic, 25% growth in adjusted EBITDAC, adjusted EBITDAC margin in excess of 32% and 20% growth in adjusted EPS. We have a culture that our people believe in, embrace and live every day. It’s a culture that will continue to drive us forward. That is the Gallagher way.

Okay. I’ll stop now and turn it over to Doug. Doug?

Douglas Howell: Thanks, Pat, and hello, everyone. A fantastic fourth quarter to close out another outstanding year. Today, I’ll start with our earnings release, touching on organic margins and the Corporate segment shortcut table. Next, I’ll walk you through our CFO commentary document, point out a few items for the next quarter and also provide a first look at our typical modeling helpers for ’23 then I’ll finish up with some comments on cash, M&A capacity and capital management. Okay. Let’s flip to Page 3 of the earnings release to the Brokerage segment organic table. All in brokerage organic of 11%, above the 9% to 9.5% that we foreshadowed in December. Two drivers of the upside. First, as Pat just discussed, we had a really strong finish within our P&C and reinsurance brokerage operations.

Second, our annual update of 606 assumptions added about 1 point to our headline organic. Recall under ASC 606, we must routinely update our assumptions related to the amount of services provided before and after the placement of an insurance policy. Based on our most recent operational analysis, metrics and time studies, more of our services being provided at the time of placement and more of the post placement service is being handled faster in our lower-cost centers of excellence. This causes less of our revenue to be deferred and thus, we recognized an additional $15 million of revenue in the quarter. That is a small amount relative to our total deferred revenue balance nearly $435 million, but it does cause an additional point of organic.

So we’re the call out today. From an expense perspective, our updated 606 assumptions also caused some additional compensation expense to be recognized during the quarter. The punchline of all this, our fourth quarter organic revenues, EBITDAC and net earnings got a small boost and adjusted EBITDAC margin was not significantly impacted. So 11% headline organic, 10% controlling for 606 and 120 basis points of margin expansion, that’s a terrific quarter. Looking forward to ’23, we’re currently not seeing a slowdown in our clients’ business activity. We’re not seeing signs of price moderation from the carriers, and we still have loss cost inflation and labor market imbalances. Add that to our client for sales and service culture, we are still seeing ’23 organic in that 7% to 9% range, as we stated during our December IR Day.

Same with our margin outlook for ’23. We are still comfortable with our December commentary. We think we can deliver about 50 basis margin expansion at 6% organic and fiduciary investment income could be a nice margin sweetener provided there isn’t a surge in wage and cost inflation. One other heads up for ’23. On December 20, we announced our acquisition of Buck. The business operations operates at an adjusted EBITDAC margin around 20%, so please make sure a portion of your pick for future M&A revenues reflects that versus what you might pick for our other mergers. Moving on to the Risk Management segment and the organic table at the bottom of Page 6. You’ll see 15.6% organic in the fourth quarter and full year organic in excess of 13%. Some of that growth this year comes from our clients’ business activity still rebounding out of the pandemic and getting back to levels they saw before the pandemic.

Accordingly, for ’23, we’re seeing organic revenue approaching 10%. Flipping to Page 7. The Risk Management adjusted EBITDAC margin of 19.3% in the quarter and 18.5% for the full year. We see a nice step-up in ’23 with margins around 19% even as we continue to make investments to enhance the client experience and in analytics and tools to drive better claim outcomes. Another year of double-digit growth and margin expansion would be another terrific year. Turning to Page 8 to the Corporate segment shortcut table. In total, adjusted results were at the favorable end of our December IR day forecast. You also see 2 non-GAAP adjustments this quarter. First, our M&A transaction costs of $5 million after tax, mostly related to Buck and a little relates to Willis treaty.

And second, as we discussed previously, you’ll see a $31 million after-tax gain related to legal and tax matters. Now shifting to our CFO commentary document we posted on our IR website, starting on Page 3. As for fourth quarter, you’ll see most of the brokerage and risk management items are close to our December IR day estimates. On the right-hand side of the page, we’re providing our first look at ’23. A couple of things worth highlighting: First, FX. With last year’s midyear strengthening in the U.S. dollar, you’ll see some volatility in how FX will impact our brokerage and risk management results in first half versus second half of ’23. Please make sure to consider these impacts as you’re planning your models. Second, our adjusted tax rate.

With the U.K. corporate tax rate increasing to 25% effective April 1, we’re providing our current estimate for full year ’23 tax rate. More of an impact to our Brokerage segment than it is to our Risk Management segment, given the size of our U.K. retail London specialty and reinsurance brokerage operation. And one other thing. The left side of this page might be a nice reference when making your picks for quarterly margins given our quarterly seasonality. And finally, when you do make your margin picks, recall we were still in the Omicron portion of the pandemic during the first quarter of ’22. So we’re not expecting as much margin expansion in first quarter as we are in the second, third and fourth quarter of ’23. Okay. Moving to Page 5. This page is here to highlight the incremental cash flows from our clean energy investments over the coming years.

And remember, those come through the cash flow statement, not the P&L. You’ll also see that we have $773 million of available tax credits as of December 31, ’22. And that we forecast using about $180 million to $200 million in ’23 and that should step up a bit in ’24 and each later year. That’s a really nice cash flow boost to help fund our M&A. The way I look at the math, it might say that an additional $773 million of free cash, combined maybe another $70 million of recurring EBITDAC at that 10 to 11x multiple, which would then have a nice arbitrage for our current trading multiple. Moving to Page 6 on the rollover revenue table. For the fourth quarter, rollover revenues came in higher than our December IR day guidance. Most of all of that came from reinsurance.

Over the last 3 weeks, cedents have been closing their books for ’22, and we’re getting updated ceded premium figures. That translated into additional commission revenue for ’22. For the sake of clarity, nearly all of that upside is excluded from our organic results because it likely relates to pre-December 1, ’22, which marked the first year anniversary of the acquisition. And no — also, please note that not all of that hits the bottom line because of production and incentive comp expense on that additional revenue. That said, it’s terrific to get the bump-up. Staying on Page 6, but moving down to the bottom table. That table shows our actual reinsurance acquisition results. In a transition year, the team overperformed our pro forma expectation.

That’s impressive and terrific work by the team. So now let me move to some final comments on cash, capital management and future M&A. At December 31, available cash on hand was about $325 million. Our current cash position, combined with strong expected cash flows and incremental borrowing positions us well for our pipeline of M&A opportunities. In total, we estimate towards $3 billion to fund potential M&A opportunities during ’23, which would include paying for Buck. And also yesterday, our Board of Directors approved an increase in our quarterly dividend by $0.04 per share. That would imply an annual payout of $2.20 per share. That’s a 7.8% increase over ’22. So with a strong organic outlook, margin expansion opportunities and an ever-growing M&A pipeline, from my vantage point as CFO, we are extremely well positioned for another fantastic year in ’23.

I’d like to thank the entire Gallagher team for another great quarter and outstanding year. Back to you, Pat.

Patrick Gallagher: Thank you, Doug. Operator, I think we’re ready for questions.

See also 15 Most Undervalued Large-cap Stocks To Buy and 15 Most Undervalued Quality Stocks To Buy.

Q&A Session

Operator: . Our first question comes from the line of Weston Bloomer with UBS.

Weston Bloomer: So my first question is on the reinsurance market and the growth you saw there. It’s obviously really strong end of the quarter. And I think you’ve talked about high single-digit growth there for 2023. So did the end of the year kind of change how you think about that level of growth? Or how should we be thinking that going into next year?

Patrick Gallagher: I think we are definitely going with some nice momentum. I wouldn’t bank on some incremental big jump. But what I like about the momentum is when you come through a time like we did in this fourth quarter, it’s interesting because you actually become much more valuable to your clients. And it’s not an easy time when you’re tussling back and forth with the cedents and the reinsurers trying to get these things done, terms are changing. Attachment levels are changing. But in the end, as I said in my prepared remarks, we got the placements made, and I think we are in a very strong position going forward, number one, with those clients, but also with the opportunity to pick up some new business.

Weston Bloomer: Great. And then my second question within brokerage as well. I noticed the compensation ratio as a percentage of revenue dropped pretty materially. And I think you’d called out some back-office saves, lower benefit costs, offset by some hiring. Is there a way you can call out how much each of those had an impact? Or where I’m trying to go with the question is how much additional leverage do you have to kind of bring that lower in 2023?

Douglas Howell: All right. Let me see if I can break that out from memory here. I don’t have it in front of me exactly, but when you’re talking about being down was at 180 basis points, something like that. Yes. Is that right? I’m just going from memory, Sorry, I’ll look it up here. Probably 1/3 of that is due to the continued efficiency that we bring by being able to push work into our lower-cost centers of excellence. I think that we’ve had some technology wins in that area, too, to help us make our workforce more effective on that and didn’t have to put on additional heads as a result of that — those technology investments. And then I think that when it came to — the other 1/3 is kind of escaping you right here.

Weston Bloomer: Got it. Is there any change to the compensation structure that you make in this market, too? I know there’s some changes just, I guess, higher organic accounts, things like that.

Patrick Gallagher: No. We’re pleased to pay our people for what they do. And we haven’t messed with that compensation arrangement with our production force, in particular, in well over a decade.

Operator: Our next questions come from the line of with Autonomous Research.

Unidentified Analyst: I want to follow up on the almost 10% 2022 brokerage organic results. Would you mind giving us some more color as to how pricing and exposure and net new business drove that year-over-year acceleration in organic. And then from where you sit today, how do you see those drivers changing in 2023?

Douglas Howell: So are you asking for the quarter? Are you asking for the full year? Sorry, just so I’ve got the baseline.

Unidentified Analyst: Yes, yes, for the full year.