Arthur J. Gallagher & Co.

Good afternoon, and welcome to Arthur J. Gallagher and Company's fourth quarter 2018 earnings conference call. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. 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 meeting of the security laws. These forward-looking statements are subject to risk and uncertainties discussed on this call or describing the company's reports filed with Securities and Exchange Commission. Actual results may differ materially from those discussed today, and the company undertakes no obligation to update these statements. In addition, for reconciliation of the non-GAAP measures discussed on this call, as well as other information regarding these measures, please refer to the most recent earnings release and the other materials in the investor relations section of the company's website. It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.

Thank you, Devin. Good afternoon, and thank you for joining us for our fourth quarter and full year 2018 earnings call. With me today is Doug Hall, our Chief Financial Officer, as well as the heads of our operating divisions. As I do each quarter, today I'm going to touch on the four key components of our strategy to drive shareholder value. Number one is organic growth. Number two is growing through mergers and acquisitions. Number three is improving our productivity and quality. And number four is maintaining our unique culture. The team once again executed on all four, resulting in another great quarter and a fantastic year. Let me start with some financial highlights for the quarter. Our core brokerage and risk management segments combined to deliver 11% growth in revenue, 5.8% all-in organic growth, adjusted EBITDA margin expansion of 45 basis points, and we completed 19 tuck-in mergers during the quarter representing about $90 million of annualized revenue. And let's not forget about clean energy. $22 million of after-tax earnings in the quarter, bringing the full year total to almost $119 million. Just a great performance by the team. Now for some more detail on our results, starting with the brokerage segment, organic. Fourth quarter organic growth was 5.6% all in. reflecting strong base commission and fee growth of 5.9%. Combined, supplemental and contingent commission growth was 1.7%, light by about $2.5 million in the quarter, mostly related to catastrophe loss experience. This shortfall didn't move the organic needle much, but it did pull our brokerage margin expansion down from 65 to 70 basis points to 46 basis points. Regardless, a really strong result by the brokerage team in the face of a tough comparison from last year's fourth quarter. Let me break down our fourth quarter organic growth around the world. First, our domestic property casualty operations had a really great quarter with base organic of over 6%. Our domestic retail benefits operation was closer to 2%, which is good performance given that the unit was up against a tough comparable of nearly 8% in the fourth quarter of 2017. Outside the U.S., our U.K. operations posted 8% organic, Canada was up 6%, and Australia and New Zealand grew around 9%. Property casualty rates and exposure combined are trending higher across all major geographies and continue to be a modest tailwind to our organic growth. Similar to last quarter, these two factors added a little over a point to organic. Let me give you some rate sound bites during the quarter, focusing on a few noteworthy lines of business. In our retail PC business, commercial auto and property lines are up about 5%, and workers' compensation is down a little less than a point. In our domestic wholesale operations, property and commercial auto lines are up 4%, casualty lines up 3%, and workers' compensation down over 3%. U.K. retail is flat or modestly positive across almost all lines with the exception of professional liability, which we see up over 5%. In Canada, property is up more than 4%, while commercial, auto, and casualty lines are up less than 4%. And finally, Australia and New Zealand continue to show the strongest impact. Casualty and specialty lines are up over 5%, and property is up around 9%. Overall, the PC market remains stable, similar to past quarters, but we do see it trending just a little higher than, say, we saw in the fall of 2018. Regardless, it's a market that is good for brokers, it's good for carriers, and most importantly, it's good for our clients. Looking forward, 2019 brokerage organic growth feels like it will be around 5%. Next, let me talk about brokerage merger and acquisition growth. 2018 was an outstanding merger and acquisition year. We completed 44 mergers representing about $318 million of annualized revenues. I would like to thank all of our new partners for joining us, and I extend a very warm welcome to our growing Gallagher family of professionals. Looking toward 2019, our merger and acquisition momentum continues. So far this year, we have announced seven mergers representing about $130 million of annualized revenue. In addition, our internal M&A pipeline report shows around $350 million of revenues associated with about 50 term sheets either agreed upon or being prepared. While not all of these will close, the continued strength in our pipeline shows our ability to attract tuck-in merger partners at fair prices who are excited about our capabilities and believe in our unique culture and realize that we can be more successful together. Moving to productivity and quality. As I mentioned earlier, lower contingent commissions tempered brokerage margin expansion by about 20 basis points in the quarter. But even with the shortfall in contingents, adjusted EBITDA margin was up 46 basis points in the quarter, a really nice result. The brokerage team continues to work hard to find efficiencies across the organization and further leverage our scale, helping us become better, faster, and deliver higher quality service to our clients. Next, let me move to our risk management segment, which is primarily Gallagher Bassett. Fourth quarter organic growth was a really strong 6.7%, domestic organic was 6%, and international posted 11%. In the U.S., workers' compensation and general liability claim counts are moving higher and finished the year up around 3%. Our insurance carrier business once again grew nicely during the quarter as more and more insurance carriers realized that we can customize and handle claims more efficiently. Outside the U.S., growth was excellent in Australia and the U.K., which reflects our ability to deliver superior claim outcomes for our clients anywhere around the globe. As we look forward, 2019 risk management segment organic growth feels like it will be in the 6 to 7 percent range. Moving to mergers and acquisitions, Gallagher Bassett completed two mergers in the quarter, an Australian-based provider of worker risk management services and a UK-based provider of property repair services. These are two excellent examples of the type of specialized partners we are attracting to Gallagher Bassett. In terms of margin, The risk management segment fourth quarter adjusted EBITDAG margin was increased by 17 basis points. This brought our full year adjusted EBITDAG margin to 17.4% within our 17 to 17.5% expectation. Looking forward, we see margins in a similar range next year as the team leverages its scale through shared services, increases its utilization of our offshore and domestic service centers, and invests in technology and analytics. And finally, I'll touch on what truly distinguishes our franchise, and that's our culture. It is a culture that values teamwork, ethics, client service, and a dedication to the communities we operate in. The core tenets of our culture, which have been part of this company for generations, are memorialized in the Gallagher way penned by my uncle in 1984. Every day, our colleagues get up and work diligently to maintain our culture, to promote our culture, and to live our culture. It is a culture that has also been recognized externally. This past year, we were the only insurance broker to be recognized by Forbes magazine as a world's best employer, and for seven straight years, we have been named a world's most ethical company by the Ethisphere Institute. Awards and recognitions aren't everything, but I believe these continue to show that even as we grow and become more global, our unique Gallagher culture resonates with all of our offices. Okay, an excellent quarter and a tremendous year on all measures. I'll stop now and turn it over to Doug. Doug?

Thanks, Pat, and good afternoon, everyone. Today I'll highlight a couple things in the earnings release and then move to the CFO commentary document we post on our website. But first, as Pat said, a great quarter to wrap up a fantastic year deserves special mention. I'd like to thank all of our worldwide professionals for such a strong finish. Okay, to the earnings release. Pat hit the highlights of the brokerage and risk management segments, so let's turn to page 9 to the corporate segment shortcut table. That's a little noisy, so let me break that down. First, you'll see that we had a terrific quarter for clean energy. Due to favorable December weather conditions, our clean energy earnings came through to post an additional $3 million of after-tax net earnings than we had forecasted during our December 11th investor day. That completely offset the slight shortfall in contingents that Pat mentioned earlier. In effect, a nice weather hedge for our total corporate earnings. I know it isn't technically a hedge, but it certainly worked that way this quarter. Second, you'll see that we had two favorable items that we have adjusted out. So looking at the last line in the fourth quarter table that's at the top of page nine, that's the adjusted line, you'll see that our corporate segment came in about $5 million better than the midpoint average. we provided during our December IR day. The first adjustment is the favorable impact of reorganizing our legal entity structure. A $22 million benefit from releasing the tax valuation allowance. It's not really a cash item this quarter, but it does help reduce our ongoing administrative costs, and it will reduce cash taxes paid over the next 10 years. equates to a couple million dollars a year of cash savings going forward. The second adjustment is an $8.9 million favorable impact from clarifying guidance issued last month related to the Tax Reform Act passed in December of 2017. It clarifies how the U.S. taxes earnings of our foreign subsidiaries. I'll come back to the other corporate segment line items in a few minutes when we get to the CFO commentary. Next, flip to page 10 of the earnings release. The third item from the bottom called other. We did sell a small brokerage unit in January. We thought the product and customer service offering fit better with the buyer's underwriting business, so it ended up being a nice win-win for both of us. Let's go now to the CFO commentary document, to page 2. We've now provided our first look at items for 2019. Two modeling notes. First, amortization expenses. Please take a quick look at your brokerage segment amortization picks. We're forecasting $74 million in the first quarter, and as the footnote says, you'll need to tick that up a couple million a quarter for M&A that we could do for the rest of the year and now get you close. Second, the earnings from non-controlling interest line. Our first quarter is when our brokerage segment has the largest impact from earnings from non-controlling interest. Please double-check your models as this has caused some modeling noise in the past. Let's now turn to page three, to the corporate segment. Let me walk you through that page. First, the blue section is just a reprint of the corporate shortcut tables from our earnings release this year. Next, we've added the yellow adjusted section to remove the favorable tax items I discussed with you a minute or so ago. We believe the yellow adjusted numbers are more helpful when comparing to both the gray section, and that's just a reprint of our estimates given last month during our December IR day, and in comparison to the pinkish section, which is our first estimates for 2019. Let me take each line in that table. Interest in banking. Our fourth quarter came in better than our December estimates, call it a million dollars after tax. Stronger cash flows in the fourth quarter kept us out of our line of credit. Our borrowings are a little bit lower. As for 2019, again in the pink column, you'll see that our estimates for interest expense are going up to reflect our additional $600 million of borrowings, as noted in footnote one on that page, and also in the 8K we filed with our earnings release this afternoon. We'll use all of that for M&A, which I'll touch on later in my comments. Moving down to the M&A expense line, M&A expenses ran a little hot in the fourth quarter, coming in about $4 million more than our estimates. It's simply more external legal and due diligence costs related to two international deals that we've recently announced and one larger domestic deal that we pulled the plug on in December. Looking forward, we see 2019 more like the first three quarters of 2018 than we do the fourth quarter of 18. The corporate line, adjusted fourth quarter came in about $3 million better than our December IR day forecast. Looking forward, we again see 2019 being more consistent with adjusted 2018. So let's go next to the impact of tax reform line. While the guidance gave us a benefit in 2018, unfortunately other guidance takes away a different benefit in 2019. So you'll see that 2019 is more in line with the adjusted amounts in the yellow column. But again, it's very important to remind you that this line is mostly a book expense, not cash, because the additional taxes are nearly all offset by the use of our credits. In the end, tax reform has been a home run for Gallagher. Finally, to clean energy. As I mentioned earlier, fourth quarter came in about $3 million better than we forecasted due to a cold last half of December. When you look at our full year 2018, we estimate that ideal weather patterns contributed about $8 million to our full year net earnings of $119 million. So now, as we and our utility partners look out over 2019, we're not expecting increased production levels from another ideal weather year. Rather, something closer to production levels we saw back in 2017. It's fantastic that we're still forecasting another year over $100 million in net earnings, but we just don't see it as being amazing as it was in 2018. Okay, let's flip to page five of the CFO commentary. you'll see that we've updated our roll-in revenue estimates for mergers that we have announced thus far this year. Usually our first quarter is a little slow, but it's certainly not the case this year. For full year 2019, looks like we can do about $1.5 to $1.7 billion of M&A with free cash and debt. That consists of $300 million of cash on hand. We'll generate another $700 million after our dividend here in 2019, plus an Another $600 million borrowing that I mentioned earlier. Of that, we used, or will use, about $500 million for mergers we have already announced and have included in our roll-in revenues in the table, meaning that we still have about $1 billion to fund additional M&A in 2019. In 2018, our weighted average multiple was around 8.3 times. and it equates to much lower than eight times when you factor in our tax credits, showing that we can execute our tuck-in merger strategy at fair pricing, which gives us a nice arbitrage to our trading multiple. Okay, those are my comments. An excellent quarter to close out an outstanding year, and we're in a really terrific position to continue our success here in 2019. Back to you, Pat.