Arthur J. Gallagher & Co.

Good afternoon, and welcome to Arthur J. Gallagher and Company's second quarter earnings conference call. Participants have been placed in 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 meanings of the security laws. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to questionary statements and risk factors contained in the company's 10-K, 10-Q, and 8-K filings for more detail on its forward-looking 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 earnings release and other materials in the investor 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 & Company. Mr. Gallagher, you may begin.

Thank you. Good afternoon. Thank you for joining us for our second quarter 2020 earnings call. Also on the call today is Doug Hall, our CFO, as well as the heads of our operating divisions. We delivered an excellent second quarter. Despite the economic deterioration caused by COVID-19, our teams are executing at the highest levels while we continue to place health and safety first. We are servicing our clients, we're selling new business, we continue to look at merger and acquisition opportunities, and our bedrock culture keeps our teams working together even while physically apart. I would like to thank our 33,000 Gallagher professionals around the globe for their constant and tireless focus on delivering the very best insurance brokerage, consulting, and risk management services to our customers. More than ever, these are times when our global capabilities and resources support our local professionals as they help our customers navigate these challenging times and still generate strong new business. That really truly is the Gallagher way. Moving to our second quarter financial performance. We grew our combined brokerage and risk management revenues in the second quarter organically and through mergers and acquisitions, and together with our expense control actions, delivered excellent growth in EBITDA and net earnings. This demonstrates that our investments over the last decade have enabled us to quickly adjust our workforce and expense base, increase the utilization of our centers of excellence, efficiently work remotely, improve our productivity while always raising our quality. Let me break down our results further, starting with our brokerage segment. Reported revenue growth was a positive 6.2%, and even a bit better at 7.6 when leveling for foreign exchange. Of that, 2.1% was organic revenue growth. Net earnings margin was up 364 basis points and adjusted EBITDA margin expanded by 635 basis points to 32.6%. Doug will provide some additional details on our expense control efforts, which was primarily responsible as we drove net earnings up 38% and adjusted EBITDA up 34%. Clearly a very strong quarter and pointed the team execute in a difficult environment. Let me give you some sound bites about each of our brokerage units around the world. Starting in the U.S., our retail P&C business held up very well during the quarter, delivering organic growth of about 4%. Still strong new business generation, a small drop in retention in non-recurring business, rate increases offset exposure unit declines, cancellations were not up over first quarter levels, and midterm policy modifications were still a net positive. but a bit lower than first quarter levels. All in, we are seeing similar trends in our domestic wholesale operations, but a bit of a tale of two cities. Our open brokerage business had mid-teens organic growth benefiting from strong new business and rate. Our MGA program binding businesses were backwards, about 5%, resulting from a slowdown in programs like transportation, amateur sports, and construction. However, When we look at June alone, our MGA and program businesses were showing improvement over the lower activities seen in April and May. We had an excellent quarter in Canada at more than 5% organic, driven by strong new business and higher rates. The U.K. delivered 4% organic, and Australia and New Zealand were closer to flat, where we were not seeing as much tailwind from rate. So exposure declines are weighing just a little bit more on our organic. So overall, our global PC operations reported about 4% organic in a quarter, a really strong result in a difficult environment. Moving to our benefits business, as anticipated, we saw some second quarter weakness down about 3% on an organic basis. New consulting and special project work declined in addition to a decrease in covered lives on renewal business. But we are not seeing covered lives decreasing as much as the headline unemployment numbers When I bring our PC and benefits together, the 2.1% organic here in the second quarter came in pretty close to where we thought it would be at our June investor day. Looking forward, so far in July, nearly every metric we are monitoring is trending better than the second quarter. Accordingly, based on what we're seeing today, we think third quarter brokerage organic and expense saves will be similar to the second quarter. As we move into the fourth quarter, if the economy continues to recover, it feels like organic would equal or even be a bit better than the third quarter, and we should be able to continue to deliver cost containment as well. Still a lot of economic and governmental uncertainty, but that is where we are forecasting today. Before I leave the brokerage segment, let me go a bit deeper on the PC pricing environment. PC pricing continued to move higher around the globe, with most geographies reporting 5% or greater price increases, tighter terms and conditions, and somewhat restrained capacity. By line of business, property remains the strongest, up more than 10%. Next is professional liability, up over 7%. Other casualty lines are up 5% to 10%, with umbrella rate increases at least twice that level. and workers' comp is flat to down 2%. By geography, Canada is seeing the greatest price increases up more than 8%. The U.S. is up about 7%, followed by the U.K., including London's specialty, at about 6%, and Australia and New Zealand between 2% and 3%. So PC pricing is up across the board. but client premium changes are more modest due to lower exposure units, higher deductible, reduced limits, and clients opting out of coverages. Looking forward, I see rates continuing to increase within an already firm market, and early indications from July point to continued increases in the third quarter. Before the pandemic began, loss costs were outpacing rate, and I see just as strong a case for underwriters to push for even more rate in this environment. It is certainly a more difficult market today, but not yet a hard market because most risk to still find a home. Jumping to mergers and acquisitions, we completed four brokerage mergers during the second quarter at fair multiples. 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. While second quarter mergers were lower than normal, the number of conversations with potential merger partners is picking up so far in the third quarter. Difficult market conditions and the pandemic are further highlighting the need for expertise and data-driven tools. Our platform is an excellent fit for entrepreneurs looking to support their current clients, use our tools and data to grow their businesses, and advance their employees' careers. As I look at our M&A pipeline, we have about 40 term sheets signed or being prepared, representing around $300 million or so of revenue. Based on the activity we are experiencing in July, we are optimistic we will return to more normal levels of merger activity later this year. Next, I'd like to move to our risk management segment. Second quarter revenue was in line with the guidance we provided at our June IR day. with reported revenues down about 8.8% and organic down about 9.6%. This reflects a dramatic pullback in new claims arising due to higher unemployment and a reduction in overall business activity, offset somewhat by an increase in COVID-related claims. We think April was the worst of it, and I'm encouraged that claim counts in the later half of the quarter and into July improved off the lows. However, New claims arising are still well below pre-COVID levels. Our risk management team also did a terrific job on cost containment. Adjusted EBITDA was only $2.7 million lower in the quarter relative to last year and margins held, which is also right in line with our expectations. It takes a little longer to turn this ship versus our brokerage segment, so we would expect to see third quarter EBITDA improve relative to second quarter, and then as our expense actions are fully realized, even greater improvement in the fourth quarter, leading to full-year adjusted EBITDA at least equal to 2019. Just a fantastic job by the team to adjust our expense base and rebalance claim loads across adjusters while maintaining our client service and quality levels. So when I combine our core brokerage and risk management segments together, despite the unprecedented economic challenges, we grew our adjusted revenues 5.3%. It grew our net earnings and adjusted EBITDA about 30%. That's truly an excellent quarter. But before I turn it over to Doug, let me finish with some comments on our bedrock culture. When times are tough, teams can either break apart or band together. Since my grandfather started the company in 1927, we have consistently expected every leader and associate at Gallagher to live our culture, talk about our culture, and promote our culture. Culture matters. Culture prevails. Culture is important in the best times, but even more important during challenging times. Our team is together. We respect and support one another. No one is an island. There are no second-class citizens. We learn from each other. Everyone is important. For those of you that have followed Gallagher since we came public more than 35 years ago, you'll recognize those statements as just a few of the 25 tenets of the Gallagher way. This document puts our core values into words, which shapes and then guides our culture, and we believe in it because it matters to us. We live it every day, and it's guiding us through these challenging times. I believe we will emerge on the other side even stronger than we were before. Okay, I'll stop now and turn it over to Doug. Doug?

Thanks, Pat, and good afternoon, everyone. Like Pat said, solid top-line growth and truly remarkable bottom-line performance. Our combined brokerage and risk management at Dusted EBITDA is up nearly 30% over second quarter last year. Many thanks to all of our colleagues around the globe for digging deep on our cost control efforts, all the while continuing to deliver unique insights and high-quality service that our clients need even more in these times. Today I'll spend most of my time on our expense savings, give you some comments using the CFO commentary document, and then finish with thoughts on cash, M&A, and liquidity. All right, let's go to the earnings release, pages 4 and 7. You'll see both the brokerage and risk management segments expanded adjusted EBITDA margins this quarter. Our brokerage segment reduced compensation and operating costs by about $60 million versus prior year when you adjust that for role and impact of mergers closed after March 31st, 2019. In the risk management segment, the savings abounded to about $14 million. So in total, we were able to adjust our expense base by about $74 million during the second quarter. That's at the top end of our estimates that we provided in April and again at our June IR day. Let me give you a breakdown of these savings. We reduced travel, entertainment, and advertising by about $24 million. We reduced technology, consulting, and professional fees $14 million. Reduced outside labor and other workforce actions saved about $13 million. We saved on office supplies, consumables, and occupancy costs of about $12 million, and lower medical plan utilization by our employees saved about $11 million. When I look towards the third quarter, I think savings will be in the $65 to $70 million range relative to last year, again adjusting for roll-in mergers. This is a bit lower than second quarter simply because our production staff is beginning to travel to see clients and prospects. We are increasing our advertising costs again. And in June, we did see a reversion to pre-pandemic levels of our employees utilizing our medical plan. As for the fourth quarter, that all depends on what happens with organic. If we're at plus 2% or plus 3% organic, then our producers are likely traveling more, and we may restart some of our postponed investments. and thus we wouldn't see as much savings in areas like technology, consulting, and professional fees. But if organic is flattish, we'd expect to see a similar level of savings as the third quarter. Okay, let's go to the CFO commentary document that we post on our IR website. On page two, most of the items are fairly straightforward and consistent with what we provided to you in our June IR day. There's two items to highlight, which basically offset one another. First, foreign exchange in our brokerage segment was slightly unfavorable this quarter. Call it about a penny. And second, in the brokerage segment amortization, that came in about a penny favorable, again, offsetting the FX. Flipping to page three to the corporate segment table, relative to the midpoint of the guidance we provide at our June IR day, interest in banking came in about a penny or so favorable. The acquisition line came in just a little bit less than a penny, but still favorable. The corporate line is about a penny unfavorable, but you'll read in footnote three that that was simply due to foreign exchange rates bouncing around in the quarter. Finally, clean energy was a penny below the midpoint of the range due to mild temperatures, more use of natural gas, and weaker electricity consumption due to COVID. A hot July has started off a strong third quarter, but we are still seeing natural gas prices on the lower end and lower economic activity could likely dampen generation later in the second half of the year. So we have lower to bet our full year range to $60 to $70 million net after-tax earnings. But let's not forget the billion dollars of tax credit carry-forwards we have on our balance sheet. That's effectively a receivable from the government that should allow us to pay lower cash taxes for many years to come. All right, let me wrap up with some comments on cash, M&A, and liquidity. Our customer cash receipts were strong during the quarter, rebounding in May and June after a slight slowdown in early April. So far in July, we're tracking back to pre-pandemic levels, so we don't see any concerns at this time. As of today, we have more than $1.3 billion of liquidity consisting of available cash on hand of nearly $275 million, and we have access to over a billion dollars on a revolving credit facility. As for M&A, as Pat mentioned, we did complete four acquisitions during the quarter. A couple were tax-free exchanges, so we used a little of our stock, but even then, with an average multiple paid below eight times, there was a nice arbitrage to our own trading multiples. More importantly, our pipeline is really heating up. So we could have a strong finish to the year and a strong start early next year. Okay, those are my comments, a great quarter by the team for them to continue growing revenues and executing on cost containment. Let's keep the economy from another clinch, we should pull off an excellent full year. Back to you, Pat.