Arthur J. Gallagher & Co.

Good afternoon and welcome to Arthur J. Gallagher & Company's 3rd quarter 2019 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 certain risks and uncertainties discussed on this call or described in the company's reports filed with the 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 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 James Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.

Thank you, Devin. Good afternoon. Thank you for joining us for our 3rd quarter 2019 earnings call. With me today is Doug Hall, our Chief Financial Officer, as well as the heads of our operating divisions. Let me just start by saying we had another excellent quarter. Our combined brokerage and risk management segments delivered 13% growth in revenues, .8% all-in organic growth. A just EBITDAG margin expansion of 66 basis points, and we completed 14 mergers with about $85 million of estimated annualized revenues. Just a terrific quarter by the team. Today Doug and I are going to spend our time focused on the four key components of our strategy to drive shareholder value. First, organic growth. I'll review organic by geography, comment on the pricing environment, and give you some insight regarding exposures. Second, growing through mergers and acquisitions. Third, productivity and quality. Doug will hit this topic after my remarks. And fourth, maintaining our unique culture. Okay, to organic. Let me start with the brokerage segment. Third quarter organic was .8% all-in, which is similar to our organic performance through the first six months of 2019. I'm very pleased that all of our divisions globally contributed to this result. For example, our domestic retail PC operations had another strong quarter with organic of about 5%. Our wholesale operations had an excellent quarter, posting about .5% organic. This includes over 10% in our domestic open brokerage operations. Our benefits operations also had a strong showing this quarter, posting base organic of about 4.5%. And then internationally, our retail brokerage operations combined to post 7% organic, with Canada up more than 10%, Australia and New Zealand up about 6%, and the UK up 5%. Another really strong quarter of production by the team. Let me move to the rate environment. We've been hearing a consistent message, whether it's from our carrier partners at the CIAB and the WSIA conferences, or from our global leaders during our recent strategic planning sessions. Rates continue to increase across nearly all areas of the market. Our own internal data also points to an increasing PC rate environment, with global PC pricing up about 5%, which is a bit stronger than what we saw in our midyear internal pricing survey. Let me break down what we are seeing. I'll start in the US. Rate overall is up around 5% in our retail operations, with workers' compensation the only line not showing incremental pricing strength relative to the second quarter. Within our domestic wholesale brokerage operations, pricing is approaching 6%. Moving to the UK. UK retail pricing is up over 3% to touch higher than the second quarter. In our UK wholesale operations, pricing is approaching double digits across many lines. In Canada, pricing is up around 8%, with property increases more than 10%. And finally, in Australia and New Zealand, pricing is up around 5% to 6%, about a point lower than what we had been seeing over the previous two years, but still a substantial increase. Moving to exposures. In early October, we surveyed our producers specifically asking questions related to their clients' payroll and exposure units. Over 75% said their customers' payrolls and exposure units grew during the third quarter. And more than 95% of these respondents said they were seeing similar or stronger client exposure growth as they begin working on 2020 renewals. This is consistent with the results from our May 2019 benefits benchmarking survey, where more than 70% of the 3,900 employers believed that their revenue would be increasing over the next two years. So when I look around the world, PC rates and exposures continue to move higher. This is an environment in which our talented production staff excels by delivering the best insurance, risk management, and benefits consulting advice by leveraging our vast array of resources and capabilities. As I sit here today, I see our fourth quarter organic nicely in the mid 5% range. Next, let me talk about our brokerage merger and acquisition growth. In the quarter, we completed 11 tuck-in brokerage acquisitions with estimated annualized revenue of $70 million. I would like to thank all of our new partners for joining us, and I extend a very warm welcome to our growing family of professionals. The brokerage team has had a very busy M&A year, completing 35 mergers with more than $330 million of annualized revenues during the first nine months. Adding to that, we have already announced the number of mergers in October that should add an additional $90 million of annualized revenue. This is on top of our M&A pipeline report that shows $400 million of revenue associated with about 50 term sheets either agreed upon or being prepared. While not all these transactions in the pipeline will ultimately close, as I look around the world, it's clear that our tuck-in merger opportunities remain very robust. Next, I would like to move to our risk management segment. Third quarter organic growth was 5.7%, with similar results in both our U.S. and international operations. The growth we are experiencing is also broad-based by client type, including large commercial, public sector, alternative markets, and insurance carrier clients. Our investments in innovative products, like the award-winning mobile app GBGO, combined with our expertise by product and industry continue to set Gallagher-Baston apart from the competition. Looking forward, we see -single-digit organic growth in the fourth quarter. In terms of mergers and acquisitions, we completed three risk management acquisitions this quarter, adding annualized revenue of about $15 million. These acquisitions provide us with incremental capabilities and services that will benefit our clients in Australia, the U.K., Europe, and the U.S. I'd like to extend a very warm welcome to our new Gallagher-Baston professionals. Lastly, I'd like to touch on a true competitive advantage. That's Gallagher's unique culture. It is a culture that helps us attract and retain the very best talent, a culture that promotes our relationships with our carrier partners, a culture that distinguishes us from others in a highly competitive merger environment, and it is the basis for our people coming together as a team to serve as clients focused on doing the right thing. Nowadays, we are hearing a lot about company culture and purpose. This is nothing new to Gallagher. We've long valued all of our stakeholders as defined in our mission statement. Ultimately, we believe if we provide value to our clients, take care of our employees, and build strong relationships with our insurance carrier partners, our shareholders will be rewarded. Bottom line, our culture always has been and will continue to be a true competitive advantage. Okay, a great quarter in the first nine months. I'll stop now and turn it over to Doug. Doug?

Thanks, Pat, and good afternoon, everyone. I'd like to start by thanking the team for another outstanding quarter. It really does position us very well to close out an outstanding 2019 here in the fourth quarter. Today, I'll make a few comments from the earnings release. I'll walk you then through the CFO commentary document we post on our website, and I'll conclude with some comments on cash and M&A. Okay, let's go to the bottom of page five of the earnings release, the brokerage segment margins. For the quarter, we delivered 68 basis points of adjusted margin expansion. That's a terrific result on .8% organic growth, and this marks the 32nd straight quarter of brokerage segment margin expansion. A truly amazing run and an excellent illustration how we're constantly focusing on raising our quality and productivity. Looking forward, we would expect to see about 50 basis points of margin expansion if organic growth is in the low to mid 5% range. Let's flip to page six of the earnings release to the risk management segment margins. During the quarter, we posted 18 points of adjusted EBITDAQ margin. That's really great work by the team, but well above the upper end of our targets. So we wouldn't expect to see that in the fourth quarter. Perhaps more like 17 to 17.5%, which would finish off a year nicely towards the higher end of our full year target, also in that 17 to .5% range. Let's now move to the CFO commentary document that we can find at our website. Let's turn to page two. Relative to third quarter estimates that we provided during our September IR day, nearly all of the lines came in very close. A few other comments. First, our integration efforts, mostly related to the aerospace and stack house mergers we did this summer. Both are moving along as planned and on budget. Second, we're making nice progress on our back office support layer transformation project we discussed at our IR day. We've already contracted a few hundred positions and we have a nice line of sight into areas where we can lower our costs and improve our service quality by centralization, standardization and automation of most of our back office functions. We're redeploying these savings into processes to help us drive our organic growth. Sales support and sales management systems and tools, data and sales analytics, additional production talent, marketing and branding. In other words, all our efforts that will help us sell more, hire more and acquire more. And finally, still on page two, a modeling note. Please make sure your models are picking up our estimates for changes in estimated earnouts and also earnings from non-controlling interest. Neither are big numbers but still can move your estimates by a penny or two. We'll stay in the CFO commentary document but flip to page three, to the corporate segment. Relative to the estimates we provided during our September IR day, interest and corporate expense lines were both within the range. Acquisition expense was just a touch higher, mostly due to a couple smaller international deals. And then finally to clean energy. You'll see that the third quarter adjusted results came in a couple million dollars above the midpoint of the range, a great quarter. Looking forward, fourth quarter is looking a bit lower than what we were seeing during our IR day. Weather thus far in October is not nearly as hot as last year. So we moderated our fourth quarter outlook just a bit. That said, it's stacking up to be another $100 million a year for this investment strategy. You'll also see a clean energy adjustment line this quarter. The clean energy had a very busy quarter. Footnote two describes four items. We resolved a five-year patent squabble with a great outcome. We prevailed in tax court. We opened new patent defense litigation which we think is without merit but we intend on spending it vigorously. And finally, we're making terrific progress in moving three of our 2011-era lower production machines into really great 2009-era locations. You can see this clearly on page four of the CFO commentary. It's in the fourth row on that page. It shows the machines are currently producing less than a million dollars of earnings here in 2019, but by moving them, we could achieve 10 to 15 million dollars of earnings. Hats off to those engineers and operators that we used to make this happen. Really a great job. It's also affirmation from our utility partners that we truly have an excellent process and that we are delivering substantial environmental benefits. Let's stay on that page four. You'll see that we are also providing numbers around what we think is possible for clean energy earnings in 2020. That's the far right columns. These numbers are still in line with what we said as a very early look during our September IR day. You'll see that by moving these machines, we can counteract the natural trends in power production towards renewables and natural gas. It's an early look. A lot can change, but here we are a decade later and still looking at an investment strategy that can deliver great returns for a couple more years. At the end of the quarter, we have over 950 million dollars of credit carryovers on our balance sheet and at least another two years of production ahead of us. So we're well positioned to harvest those hard to earn cash flows well into the mid to late 2020s. Finally, let's move to cash and M&A. At September 30, we had about 300 million dollars available cash on our balance sheet. This, plus our free cash flow through the end of the year and our borrowing capacity should round out a year where we can still invest deeply in our business, pay a great dividend and still fund about 1.5 billion dollars of M&A before using any stock. When I look at our pipeline through year end, I think we'll be close to that level and if we happen to go over, it would only mean using a very small amount of stock. This clearly demonstrates the strength of our growing cash flows. When I look out towards 2020, it looks like we can easily do another 1.5 billion dollars of M&A without using any stock. So those are my comments. An excellent quarter, an excellent nine months. Back to you Pat.

Thank you Doug. Devin, we're ready for questions if we have some. Could you open it up?

Thank you. The call is now open for questions. If you have a question, please pick up your handset and press star one on your telephone at this time. If you are on a speakerphone, please disable that function prior to pressing star one to ensure optimum sound quality. You may remove yourself from the queue at any time by pressing star two. Again, star one for questions. One moment please while we flow. Our first question comes from the line of Mike Zemreski with Credit Suisse. Please see with your question.

Hey, good afternoon.

Good afternoon Mike.

First question, so as you guys know better than I do, there's a lot of commentary about the P&C commercial market hardening and there's certain views out there that rates will continue to harden. I know Pat, you've said that 5% is no hard market and you said you've got to go all the way back to 2001 to see what a real hard market looks like. Since it's been a while, let's just, if we had to hypothesize that rates did continue to move north, maybe you can help us understand what a hard market would mean in terms of H.E. Gallagher's impact on your financials and the pluses and the minuses.

Mike, yeah, sure. Thanks for the question. First of all, you hit it right on exactly my line. This is not a hard market. It's getting firmer. There's no question about it that when you get into some higher end property stuff on or places where there have been losses, our people are working very hard to place those. Some of the stuff is getting done at the last minute. Takes more effort, more submissions to more E&S markets to get it completed. We're seeing excess casually take a little more effort and cost more money as well. But this is not 2001, 2002 by any means. There is still plenty of capacity. Deals are getting done. And remember, our job is to mitigate this for our clients. So number one, we're training our people across the globe. Get out in front of this and explain to your clients that in fact, in many instances, we can show you that your rates are lower today than they were in 2005. So you've had a very good run. This is not a knee jerk. The rates that are being requested in many instances make a lot of sense. But it's certainly not a message that anybody wants to hear. Now let me compare that with what a hard market is. And again, you got to go back to 2001, 2002. And that's when the door slams shut. You got people getting canceled left and right. Cancellation notices are going out every month. You're out trying to explain to your clients why they've been loss free and yet the XYZ insurance company is not going to renew them. And they better get ready for the consequences of significant deductible increases and possibly the reduction of limits on a drastic basis. Frankly, that's not good for anybody. Now, I've been through three or four of those in my career, and it's a little bit like going home and finding out the electric company just decided to change the current and none of your appliances work. And so that's not good for anybody. And I don't see that happening. I do see disciplined need for rate. And that is being explained by our professionals. And where necessary, we're doing everything we can to help them find cover at a cheaper price.

OK. So as a follow up, then, so if we kind of get maybe Goldilocks rates keep drifting up by just a couple of points. I mean, do you expect the question we get from investors is, you know, will A.J. Gallagher continue to say, you know, it's 50 basis points of improvement or, you know, if we get into 6, 7 percent organic territory, would you expect for more of the organic to fall to the bottom line?

Yeah, Mike, it's Doug. Yeah, I think that if you got over 6 percent for a continued period of time, you would see, you could see some more margin expansion than 50 basis points.

OK, great. And just lastly for Doug, on the M&A sandbox, it's interesting. There's been some IPOs of smaller companies that have been very successful and they're trading at nice multiples. There's one this week as well. Does that have any impact in terms of maybe making the, I know the pipeline's robust, but maybe it removes some potential for some of the larger deals if, you know, if these companies find out, choose to go the IPO route?

Oh, I don't know if it makes a dramatic difference or not. I think, remember, people join Gallagher because they see our capabilities, our resources. They know that being together with us, that will be a better opportunity to deliver value to their customers. The folks that might want to IPO or go to a financial sponsor, that's really not what they're trying to do with their business. The ones that we're trying to attract, you know, we get 40, 50, 60 of those folks a year that want to come in and be better together. So it could happen, but I don't see it pulling a lot of folks away from us.

Thank you.

Thanks, Mike.

Our next question comes to the line of Elise Greensman with Wells Fargo. Please see what the question.

Hi, thanks. Good evening. My first question, at your investor day, you know, kind of just a little bit over a month ago, you guys had pointed to, you know, I believe a little bit of a slowdown in organic in the third quarter. I know, Doug, I think you said, you know, last year was a tougher comp. Obviously, the growth that you guys printed in line with what we had seen through the first six months. So did some business outperform relative to your expectations of just trying to get a sense of what might have changed, you know, in those few weeks towards the end of the quarter?

I think that we did have a good September. Yeah, we're talking about a few million bucks here. So, but if you really look at places where particularly strong are UK and London operations are really killing it right now. They're doing great. You saw good growth in Canada. You can go through where Pat talked about where we're seeing some lift there. But I think that, you know, September is a big month for us as is December. So we did have a difficult compare and I was pretty proud of the team to grow over the top of

that. Okay, that's helpful. And then so as we think about 2020, you know, it sounds like you guys are, you know, pretty optimistic in terms of what's going on with exposure growth as well as, you know, property casualty pricing momentum at least being maintained at its current level. So does it seem like, you know, 2020 can be, you know, kind of in that five and a half percent range that you're guiding to for the fourth quarter? Just any kind of initial view there?

Yeah, I think that's how we're seeing 2020. Subway is in the five percent. So remember, they're also during this time, as losses go up, you could have some programs that need to reprice, you could have some carriers decide that, you know, that they're going to pull back on some stuff. So it's the repricing piece that's always hard for us to take a look at this far in advance.

Okay, that's helpful. And then I appreciate, you know, giving the color on the clean energy earnings for 2020. So there's a 20 million dollar range which just seems a little bit higher than typical. I guess why is there a slightly bigger range and how should we think about, I guess, falling towards the higher end versus the lower end of that range for next year?

Well, it's a long ways away. There's still, the utilities are still doing their budgets. We pulled them here during the last month to see if we can get an early look. So we typically don't provide this to January. So I'd expect to narrow that range. But also when you look at the utilization of coal for electric power sector production, you know, in 2018 it had been declining about 3% a quarter, maybe 4% a quarter. We had a big drop off in April through June of this year and a second quarter. I'm just looking at some of the statistics you can find out on the EIA. And they were down 18%. That's weather related more than it is displacement. But if you really think about it, the line to look at is the 50 to 60 million dollars where the production related to those plants that were making us 56 to 58 million this year. You know, that's maybe a 4 to 5% pullback in the numbers, maybe a little bit more. But, you know, between 80 and 100 million we're still really darn happy with this. When we set out 10 or 11 years ago to do this investment strategy, the idea of us making, called the midpoint, there ain't $90 million in the ninth year. That's, I don't think we would have dreamt of that. So we're pretty proud of that effort.

Okay, that's helpful. And one last quick question. Your acquisition revenue on page five for the fourth quarter, the 116 million, that's about 21 million higher than what you guys had provided at that September IR day. Is that, it's like one deal driving that from either, that was announced in the fourth quarter, is that just a compilation of some of the smaller deals you announced in the fourth quarter to date that flow into the fourth quarter?

Elise, can you just restate the question? You're looking at something in the fourth quarter, our estimates for roll in revenue is $116 million, right? Is that what you're looking at? Yeah, so that's,

yeah, so that's 21 million higher than what you had told us at the IR day. So is that, is there one big deal that you announced since then that benefits the fourth quarter that much? Or is it just more, a lot of deals that were announced since September?

All right, so I think some of the Q4 deals that came in, call it half of that, it's different than we closed the Q4 deal. And then also I think the JLT, the aerospace business, we've got a better line of sight on what we think is rolling in from that.

Okay, that's helpful. Thank you very much. Thanks, Elise. Thanks, Elise.

Our next question comes to the line of Yaron Kinnar with Goldman Sachs. Please see with the question.

Hi, good afternoon, everybody. First question is around the EBITDAQ, adjusted EBITDAQ margin and the brokerage business up quite a bit year over year. And even seasonally seems to be quite strong here. And then as I recall, I think Doug, you'd said in the past that second half of the year has a little bit of weakness just because of the salary increases or compensation increases that come in. You know, I'm looking now at three years in a row where the third quarter is actually quite seasonally strong. Is there any change in how you're thinking about seasonality here? Any driver for a particularly strong result here?

You know, I think the biggest answer is the team did a really nice job. We kind of put the clamp on hiring. And, you know, when you're hiring, you know, 350 people a month, you can kind of control your comp ratio a little bit by just putting the brakes on a little bit. We, you know, coming into the end of the year, we didn't want to get too aggressive on our hiring. That's probably delivering most of it in the quarter, which is a little different than typically we don't do that until the fourth quarter. So I think the team just got ahead of it a little bit.

Okay. And do you think there's a timing issue here? I would just think there was, you know, forming markets and opportunities maybe the hiring will still commence.

Yeah, we're always out there looking for producers. We're always doing that. I think that you're really seeing some of the economies of scale coming through. We did, you know, we did do a riff. You know, if you recall some of that. Now, I wouldn't call 300 people a riff on 34,000, but we did a tightening of the belt in, you know, June and July. So that's part of it. But also, we're just getting good results by utilization of our offshore centers of excellence, we're getting good results through our technology lifts. It's just you get these economies of scale as you get, as the business grows.

Okay. And with that in mind, then, as we look forward, do these, I think in the past you'd said, you know, anything about 4% growth should achieve, what was it, 30 basis points of margin improvement or 40 basis points of margin improvement, 5% organic growth, we'd get a little more than that. Should we expect an acceleration of that given the economies of scale?

Here's two things that we'll look at. We'll look really hard. The team's having a terrific year, so we'll look at how the bonus expense looks in the fourth quarter. I think that, you know, we still feel comfortable for posting over 5%. We'll get 50 basis points of margin expansion.

Okay. Second question, if I may. Contingent commissions, you know, if the industry's raising rates in a rational way, basically to address inadequate returns, I would think, should one expect a decrease in contingent commissions over the next 12 months?

Well, from numerically, contingent commissions, you know, you could have a little flattening in the growth of contingent commissions. If you think about us, you know, we've got hundreds and hundreds of contingent commission contracts out there all around the world. That sell of business that's loss ratio sensitive, let's call it $50 million of annualized earnings, you know, if it flattens out, you'd probably get paid back for that in the base commission and fee line as you get some rate left and some exposure left, so overall, all in organic, shouldn't suffer two terribly months based on what we're seeing in the loss ratio environment right now.

Got it. Thanks so much.

Thanks, Sharon.

Once again, if you would like to ask a question, please press star 1 on your telephone keypad. Once again, if you would like to ask a question, please press star 1 on your telephone keypad. Our next question comes from the line of Meijer Shields with KBW. Please, see what their question.

Great. Two quick questions, if I can. I want to follow up on your own question and ask whether the deteriorating casualty environment that we're hearing a little bit about this quarter is translating into more claim, more liability claims handling within risk management.

Well, there's no doubt. I mean, we're seeing, first of all, we are seeing tort inflations, Pat. We're seeing tort inflation across our book of business, in particular in areas like transportation, sexual misconduct and D&O and places like that. Our liability book and severity in the liability book at Gallagher-Bassett, it's both up in terms of numbers of claims as well as the settlement amounts that are being paid to close.

Okay, is there

any way of- There's clearly tort and for inflation.

Okay, and that sounds like it would be good for risk management revenues.

It should be because a big part of what we're trying to prove in the marketplace and realize we're getting to a size now as the risk management claims provider that many of our own trading partners don't handle the number of claims Gallagher-Bassett does. So we're trying to point to the fact to carriers, to captives and to risk management clients that if they select Gallagher-Bassett, their results will actually be better. We will have a better claim outcome than they're used to in the general market. And we do believe we can stand up to that. So yeah, I mean, as people start to feel the squeeze and as the settlement costs go up, more of a reason to listen to our story.

Okay, excellent. And second question, I guess if you look back, I'm interested in how accurate past surveys of client growth have been in terms of predicting how the economy actually pans out.

Really, really good. Our people are on the street. This is not a survey of a bunch of economists that are sitting in Washington, D.C. These are people sitting across from customers right now planning for 2020. And they're not going to be pie in the sky because the fact is when you tell us your payrolls and your other exposure units sales are going up, you're going to have a higher deposit on your insurance premium. So there's a natural tendency to lowball. And if you lowball, you get a free loan from the insurance company. So no, no, no, these guys really have their ear to the ground.

Okay, that's fantastic. Thank you.

Thanks, Mayor.

Thanks, Mayor.

Our final question comes to the line of Mark Hughes with SunTrust. Please see with your question.

Yeah, thank you. Good afternoon. Good afternoon, Mark. Doug, the one point five billion in capacity for next year, could you refresh us on how much of that you had anticipated to be free cash and then how much you would borrow? And then what's your capital cost? Would you imagine on that the piece that you would be borrowing?

Half would be free cash. Half would be borrowing. And what's our cost of borrowing? I know four percent, four and a quarter or something like that.

And then just to be clear, in the CFO commentary, your estimate for revenue contribution, that is entirely inclusive of all the deals you've done here before, including, I think you said, 90 million in acquired revenue in October. Is that correct?

Through yesterday, yes.

Through yesterday. Okay. Great. Thank you very much.

Thanks, Mark. Thanks, Mark. Any others, Devin?

There are no further questions at this time.

Great. Then let me just make one quick comment to wrap it up. Thank you again for being with us this afternoon. I'm extremely proud of what the team has accomplished so far this year, and I believe we're poised to deliver a strong finish to the year. So thanks, everybody, for being with us today. We appreciate it.

This does conclude today's teleconference. You may now disconnect your lines at this time. Thank you for your participation, and have a wonderful day.