Arthur J. Gallagher & Co.

Good afternoon, and welcome to the Arthur J. Gallagher and Company's first quarter 2020 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 include 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 risk, and uncertainty that could cause actual results to differ materially. Please refer to the cautionary statements and risk factors contained in the company's 10-K, 10-Q, and 8-K filings for more details on its four linking 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 university relations section of the company's website. It is now my pleasure to introduce Jay Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher and Company. Mr. Gallagher, you may begin.

Thank you very much. Good afternoon, everyone, and thank you for joining us for our first quarter 2020 earnings call. Also on the call today is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. Before we get into our first quarter results, let me acknowledge those directly affected by COVID-19, including those on the front lines of the global pandemic. We are in awe of their dedication and courage. Here at Gallagher, our priority is the health and safety of our colleagues. We're very fortunate that less than 50 of our 34,000 associates have contracted the virus, nearly all of whom have fully recovered. For the few that are still self-quarantined, we wish you a speedy recovery. I'm incredibly proud of how all of our associates have performed over the past six weeks. In March, we mobilized our business continuity plans around the globe, and we're up and running working from home in a few days. We are working remotely without missing a step. This is the payoff of our relentless efforts over the past decade to standardize work, streamline processes, and operate using common systems. All of our colleagues are productive, too. At home, they have the right tools and systems in order to deliver the highest quality service to our clients. And that includes more than 5,000 associates that are based in our service centers. And every day, we see countless examples of our employees unselfishly giving back from providing first responders with protective equipment to sending meals to senior citizens to distributing masks to the less fortunate. I'm proud but not surprised at the level of dedication, support, and professionalism from all of our colleagues around the world. I thank every single one of you from the bottom of my heart. Now moving to our first quarter financial performance for our combined brokerage and risk management segments, here are some highlights. We had a terrific revenue growth quarter. Total reported revenue growth of 4% and adjusted revenue growth of 9%. which includes 3% reduction due to COVID. Included in that is organic growth of 3.3%, but again, we had nearly 3% of an unfavorable impact due to COVID-19. This would have been another quarter like our fourth quarter last year. And even with around 2% adverse impact of COVID-19, we posted a net earnings margin of 20.1%, and more impressive, adjusted EBITDAG margin of 32.2%. And we completed eight acquisitions this quarter with estimated annualized revenues of $124 million. As you can probably tell from my tone, I am pleased with our quarter. But that is the past. While I wish we would have had some time to celebrate, we're now full tilt on three objectives. First, We're busting our humps for our clients, and we're doing it in partnership with our underwriting markets. This virus crisis is hitting our clients at the exact same time underwriters were already needing rate for the risks they were taking. Rates were already going up mid-single to even double digits on nearly all lines except workers' compensation. And we see it becoming even more difficult. Now is the time our producers, combined with our capabilities, can really shine. We have solutions, we have ideas, we have tools, and we have data that very few other brokers can bring to the customer. Our data would say that 90% of the time we are competing with a smaller broker that does not have anywhere near our level of capabilities. I like our win chances even better in this environment. Second, we have developed plans to ensure our employees can return to the workplace safely. We got them home safely so now it is about a measured and conservative return to the workplace process. We have proven we can work remotely so we won't be hurrying large numbers of our folks back into our offices until we know it's safe. And third, while I am encouraged by the resiliency of our business thus far in April, we must balance that early information with the reality of deteriorating economic conditions. Accordingly, We've already developed and we are already implementing measures to adjust our expense base in a staged, contemplated manner. As we see economic deterioration develop, we can implement further adjustments to our cost structure. Doug will dive deeper into this, but looks like we can lower our expense base 50 to $75 million per quarter nearly immediately. I do want to go back into some financial highlights by segments. First to the brokerage segment organic table on page four of the earnings release. First quarter organic was 3.1% all in, which includes 3.2% reduction due to the estimated impact of COVID-19. So you can see we had a terrific organic growth momentum quarter through March. Our data capabilities allow us to monitor premium changes, client retention, new business production, renewal premium changes, audit premiums, endorsements, and other rate and exposure metrics daily. During the first quarter, excluding COVID adjustments, we saw new business, lost business, and changes in exposure units similar to what we saw throughout 2019. As for pricing, when I roll it all together globally, the PC pricing environment was still up around 5% in casualty lines, up 10% in property lines, And the lone exception to that is workers' compensation here in the U.S. But even comps saw an inflection this quarter. We've been seeing rate decreases each quarter in 2018 and 19, but first quarter of 2020 showed it as flat to a small increase. So that is what we saw in the first quarter. Let me address what we are seeing thus far here in April. First, we are not seeing a meaningful change in exposure units. It's early. certainly early in this crisis, but we are just not seeing the impact yet. Also, retention is up a bit, and new business is still as strong as it was in the first quarter. Second, we're not seeing a dramatic change in pricing from what we saw in the first quarter, perhaps up a little, but not dramatically. Now, remember, all that is what we're seeing through today. So what do we see going forward? Property and casualty exposure units will certainly decrease. How much and for how long is anyone's guess. But what we do know is the concentration of our business by industry. Accordingly, we looked at our April renewals and stratified by industry into higher, moderate, and lower impact from COVID. Interestingly, it came out that 20% of our revenues are in higher impact industries, 20% in lower impact industries, and 60% in moderate impact industries. Then we looked at rate increases versus exposure unit declines. For casualty lines, rate increases were about equal to declines in exposure units in the high impact industries. And rate increases were actually more than declines in exposure units for both the moderate and lower impact industries. For property lines, regardless of high, moderate, or low impact, rate increases offset exposure unit declines by 10%. And only in workers' compensation did we see a net decrease, down 6% in high impact, down 3% in moderate, and actually up 4% in low impact industries. Finally, when we look at our employee benefits business, April information isn't showing a big decrease in covered lives. But because a large portion of that health and welfare business has January effective dates, we must make an estimate as to how many covered lives will be under the employer's plans throughout the rest of the year. Clearly, there will be decreases, but that could be mitigated in part by employers extending benefits through furloughs, periods under COBRA, et cetera. And we just don't know yet how soon or when the unemployed employees will return to work. All that said, I must caution again that this is very early. We are in uncharted territory, so these views are susceptible to significant and perhaps material changes going forward. When I look forward longer term to the rate environment, we do see rates continuing to increase. I do not see this as an up 50% environment like we saw in 2002 and 2003 post-9-11. The industry was coming off a 15-year soft market when that happened. We haven't been in a soft market. Rather, we've been in a stable rate environment for nearly a decade, up 2%, 3%, 4%, down 2%, 3%, 4%, and most recently in a slightly more firm market as rates were up even a bit more. I also don't see this like 2004 to 2011 when rates were soft. Even before COVID, losses were deteriorating, and now this crisis could cause further loss deterioration causing the underwriters to need even more rate. I wouldn't call it a hard market, but I would call it becoming a more difficult rates and conditions market. So for us, that means in the short term, a decrease in our organic growth due to declining exposure units, perhaps offset a bit by an increasing rate environment. It's very hard to predict, but we are prepared for the possibility that organic may go flat or even a bit negative for a couple of quarters. but I see that reverting to organic growth levels like we saw in 2019 during 2021. Next, let me talk about our revenue growth through mergers and acquisitions. We had a nice start to the year completing eight brokerage acquisitions during the quarter. Capscom Re was the largest one of the group and its revenues were previously consolidated in our financial results. For the other seven acquisitions we completed in the quarter, We estimate they will add another 25 to 30 million of annualized revenue. I'd 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 forward, our internal merger and acquisition pipeline report shows around $200 million of revenue associated with over 30 term sheets either agreed upon or being prepared. A bit tough to get through due diligence in this environment, so I'd call it a bit of a lull. But don't be confused. We are still having a lot of conversations with those that see how we can be better together. In fact, we're even having some success co-brokering some accounts with those merger partners that were close to signing a deal with us. Some might call that a nice joint venture as a step to full ownership. We've also seen competition slow down a bit, which might rationalize valuation multiples. Regardless, at a minimum, more consideration will need to be put on an earn-out. Bottom line, we are open for business and invite any broker anywhere around the globe to take a look at what Gallagher can offer as a merger partner. These are tough times, and we have a ton of resources to help smaller brokers continue to succeed. Next, I'd like to move to our risk management segments. First quarter organic growth was a solid 4.1%, and results were even stronger for the first two and a half months of the quarter. But since mid-March, we are seeing signs of dramatically higher unemployment and a reduction in our clients' overall business activity. However, it's important to break down this business as a bit differently than we do with our brokerage segment. A risk management business is sensitive firstly to the nature of the service we provide and then secondly to the type of entity, and then to the industry. So it isn't simply about the headline number of closed businesses nor the employment levels. Let me give you some more color. For highly specialized liability and consultative services, high severity claims, and captive risk sharing, and many governmental entities, we haven't seen a big fall off in our claim volumes. Underlying that, some industries are up, some are down, but overall about flat. Looking forward, we would expect these types of claims to hold up well during a short-lived down economic environment. That's about 70% of our revenues. Then plus-plus contracts, about 20% of our revenues. We are actually seeing 80% of those clients willing to pay for excess staffing as they are either seeing a V-shaped recovery or have chosen to keep in place established and experienced teams that have the ability to consistently drive exceptional claim outcomes. Then there's our high frequency, low severity claims, about 50% of our claims by count, but only about 10% of our revenues and our lowest margin services. Those are being hit the hardest off 50% or more. Fortunately, our risk management operation years ago shifted a large portion of our workforce to work from home. and often use temporary and contract labor to staff peak loads for much of the volume-sensitive and low-margin services. Accordingly, while revenues might decrease over the coming quarters, we believe we can adjust our expense base to absorb most of the lost revenues. Our playbook is even stronger today than what we used during the financial crisis, so we should be able to execute and still maintain our ability to deliver the very best claim outcomes for our clients. And finally, I always wrap up with comments on our bedrock culture. I have to say, I didn't think it could get much stronger, but it is really thriving in this environment. I'm on the phone every day with our leaders around the world. There's a genuine sense of energy about beating this virus and emerging in better shape than ever before. The sense of duty and advocacy for our clients, employees, underwriting partners, and shareholders has served as our compass for over nine years and will continue to do so for many years to come. And I can't end without complimenting everyone at Gallagher for being awarded our ninth straight World's Most Ethical Award. In good times and perhaps even more so in bad times, culture and ethics guide an organization, and our commitment to both of these for 92 years will serve us well in today's challenges. Okay, I'll stop now and turn it over to Doug.

Doug? Thanks, Pat, and good afternoon, everyone. I, too, extend my sincere appreciation to first responders and those on the front line, and also my thanks to our 34,000 colleagues. You had to navigate your own personal challenges presented by the pandemic, yet we're up and running in a few days delivering timely advice and service to our clients. That's just simply amazing, so thank you. Today, I'll walk you through the COVID-19 impact table on page two of the earnings release and how that impacts organic and margins on pages four to seven. I'll address our expense savings initiatives. I'll provide some thoughts on our capital and liquidity, and I'll finish with a few short comments in the CFO commentary document. So, okay, turning to the table on page two of the earnings release. This table captures all of the COVID matters in our numbers. They all fully hit our reported GAAP numbers, and we did not adjust any of them out when we show our non-GAAP adjusted numbers. You'll see in the end, COVID didn't have much impact on net earnings nor on EPS, but there are four moving estimates that have a noticeable impact on revenues and EBITDA. First, let's address how it impacts revenues. And just as a reminder about Accounting Standard 606 that drives our revenue accounting. We adopted that in 2008. Recall that it requires us to estimate annualized ultimate revenues for contracts and policies with effective dates prior to closing the books, even if those annualized revenues are dependent on future events. We must make our best estimate. And as most of you know, there are a lot of insurance policies that have volume-like adjustments that can occur in the year after the policy effective date. Lines like workers' compensation, employee group medical plans, casualty lines that have adjustable premiums based on, say, future miles driven or flown. Those are just examples. And then you have experience-rated contracts. So there's a lot, so on and so forth. In the past, historical patterns drove those estimates, and changes in volumes would emerge slowly as our clients' businesses naturally evolved. That's not today's environments. Our customers' businesses have been dramatically altered in a few short weeks. That's the reality. So we need to make our best estimates of what will happen in the future for those pre-April 1st contracts. It's not easy, but we still must do it. For those that closely follow the P&C sector, perhaps another way to think about it. We must estimate future adverse development on the revenues we booked when the contract was first effective. We must make that estimate change today versus having it develop over the next few quarters. To do this, we look at a ton of our internal data. We compare it to industry and economic data. We slice it by industry group, type of coverage, and we compare that to consumer spending patterns, et cetera. From that, we can make some informed estimates. So you'll see in the impact table on page two that about $15 million relates to P&C policies. Those are audits, cancellation, midterm adjustments, et cetera. About $18 million relates to group medical insurance policy, possible reduced monthly covered lives. And then there's $8 million related to volume and loss ratio sensitive contingent contracts. That totals to about $41 million, but really that's only about a 2.5% impact on our first quarter revenues. And also, don't forget, if we overshot the impact, it will reverse back into our revenues as new information becomes available. If we undershot, we would have to take further adverse development. Next, you'll also see there are some variable compensation offsets on that revenue impact, and also a reserve for bad debts for policies written, but for which we might not collect. We rarely have much bad debt historically, but given some of the moratoriums and cancellations, and also that business might go out of business during that moratorium, we can't chase down collections from an empty wallet. Next in that table, you'll see two non-cash items. Neither impacts our EBITDA. First, a future decline in economic condition does impact the value of our intangible asset for acquired customer lists. a $45 million adjustment. But on a $2.2 billion asset, that's just a 2% tweak, which makes sense given the life of customer lists can be 5, 10 years, or even more. Second, on the other hand, a short-term decline in economic conditions has a much greater impact on the amount of earnouts for recent acquisitions. You'll see about $87 million in the brokerage segment and $4 million in the risk management segment. On a $530 million balance sheet liability, that's just 16% of the current estimate. A much bigger percentage impact, but again, the measurement period is much shorter than the recoverability duration under intangible customer list. So once you digest the impact of COVID on page two, you can better navigate the tables on pages four through seven. Here are the punchlines from those tables for the first quarter. Brokerage organic is shown at 3.1%, but COVID-related re-estimates hurt that increase by 320 basis points. Had we not re-estimated our revenues, our organic would have been a lot like fourth quarter 2019. Brokerage adjusted EBITDA margin shows that 120 basis points down. The COVID impact hurts that by 220 basis points. Risk management organic growth is shown at 4.1%, but COVID-related re-estimates hurt that increase by 60 basis points. So that ends up about what we saw in the fourth quarter of 2019. The risk management adjusted EBITDA margin was down 40 basis points, almost all due to COVID. So with understanding the table, let's go back to page three of the earnings release. As Pat mentioned, starting in mid-March, we dove into adjusting our expense base. We are following the playbook from 2008 and 2009 financial crisis. Even though we are over five times bigger today, we have considerably more consolidated information, systems, and resources. So we have actually more levers we can quickly pull. We are implementing the changes to reduce our expense base by $50 to $75 million per quarter. That will come from reduced travel and entertainment and advertising expenses of 20 to 25 million, reduced technology consulting and other professional fees of 10 to 20 million, reduced temporary labor and attrition, 10 to 15 million, lower utilization of health and welfare benefits, 10 to 15 million. We've made great strides in April, and any further expense actions will be based on how we see revenues develop over the coming months Let's stay on page three for a second. You'll see the last few sentences address our strong liquidity position. Today, we have approximately $1.1 billion of liquidity, considering available cash on hand of nearly $300 million, and we have access to another $800 million on a revolving credit facility. That doesn't expire until June of 2024, so we're in very safe shape on that one. Over the next two years, we only have $175 million of upcoming debt maturities, $100 million in 2020 and $75 million in 2021. So there's no issues there either. Leaving the earnings release, let's go to the CFO commentary document we post on our website. It's fairly straightforward and consistent with what we've provided before. Three quick items to note. On page two, foreign exchange. The strong U.S. dollar is driving a $10 to $20 million quarterly impact on our brokerage revenue, but only equates to about a penny drag on EPS. On page three, Clean Energy posted 52 million of net earnings this quarter, but we're seeing a decline in electricity demand, both due to lesser economic activity and then also the tag-along impact of lower natural gas prices, leading utilities to favor gas over coal. So, we have brought down our full-year estimate a bit and now expect 70 to 90 million of net earnings for the full year. And also on page three, the corporate line came in better than we forecasted back in January. Almost all of that due to a favorable FX adjustment. So, okay, those are all my comments. We're in solid financial position. We have quickly achievable plans in place to adjust our expense base. So we're in strong position to whether the economic and operational challenges created by the pandemic. So back to you, Pat.