Arthur J. Gallagher & Co.

Good afternoon and welcome to Arthur J. Gallagher and Company's third 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 any 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 security laws. These forward-looking statements are subject to risks and uncertainty. 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 filing for more detail on its forward-looking statement. 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 Jay Patrick Gallagher, Chairman President and CEO of Arthur J. Gallagher and Company. Mr. Gallagher, you may begin.

Thank you. Good afternoon. Thank you for joining us for our third 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. We delivered a very strong third quarter. Despite the current global health crisis and the related economic slowdown resulting from COVID-19, our teams continue to execute at the highest levels. While we continue to place health and safety first, we are selling new business, we are servicing and retaining our clients, we continue to look at merger and acquisition opportunities, and our bedrock culture keeps us working together even while physically apart. These are times when our global capabilities, niche expertise, and product specialists support our local professionals as they help our customers navigate these challenging times. I'd like to thank our 30,000-plus Gallagher professionals for their efforts and relentless focus on delivering the very best insurance brokerage, consulting, and risk management services to our customers. That is the Gallagher way. Moving to our third quarter financial performance. We grew our combined brokerage and risk management revenues in the third quarter organically and through mergers and acquisitions, and together with our expense control efforts delivered excellent growth in EBITDA and net earnings. These results demonstrate our operating flexibility, which has enabled us to quickly adjust our expense base, optimize our workforce, improve our productivity, while also raising our quality. Let me break down our results further, starting with our brokerage segment. Reported revenue growth was a positive 8.3%. Of that, more than half, or 4.2%, was organic revenue growth. We did have some favorable timing. I'll discuss that more in a minute. Net earnings margin was up 334 basis points and adjusted EBITDA margin expanded 632 basis points to 33.4%. Net earnings up 37% and adjusted EBITDA up 32%. So another excellent quarter during a global pandemic. A fantastic job by the team. Let me walk you around the world and give you some sound bites about each of our brokerage units, and I'll start with our PC operations. In U.S. retail, another strong quarter with organic growth of about 4%. We saw solid new business and slightly better retention versus last year's third quarter. Rate increases are more than offsetting exposure unit declines. Midterm policy modifications, including full policy cancellations, are similar to prior year levels. And our U.S. wholesale operations, risk placement services, organic was 8%, and our open brokerage business even better than that, while our MGA program binding businesses returned a positive organic in the quarter. Here, too, rate increases are more than offsetting exposure unit declines. Moving to the U.K., around 2% base organic with stronger growth in our London specialty business due to firmer pricing. In Australia and New Zealand combined, also around 2% organic, with New Zealand slightly stronger than Australia. New business is down a touch in Australia and up in New Zealand. Rate increases there remain positive, but not enough to offset exposure decline. And finally, our Canadian retail operations posted organic of 8%, another terrific new business quarter and stable client retention. So overall, our global PC operations reported about 4% organic in the quarter, again, an excellent result in a difficult environment and on the higher end of our mid-September expectation. Moving to our employee benefit brokerage and consulting business, third quarter organic was positive 6%. This includes a large life insurance pension funding product sale that we expected to close in the fourth quarter. Otherwise, new consulting and special project work remains soft, while covered lives under employer-sponsored health plans continue to be more resilient than headline unemployment numbers. So when I bring PC and benefits together, organic of 4.2% and even allowing for the big benefits win, a great quarter. Looking forward to our fourth quarter. First, recall we had a terrific fourth quarter last year, 6% plus organics. So we're starting off with a tough compare. Second, I just discussed some favorable timing here in the third quarter. So I don't see us hitting 4% again. But thus far in October, PC retentions, new business, full policy cancellations, and other midterm policy adjustments are in line to slightly better than the third quarter. So perhaps we can be nicely in the 2% to 3% range. That would deliver a full year 2020 around 3% organic, which would be a great year in this environment. While there's still a lot of economic and governmental uncertainty, which makes forecasting organic a challenge, we can control what we spend. We've demonstrated over the last seven months that we can execute on our cost containment playbook. That makes us highly confident we can deliver another quarter and a full year of really strong EBITDA growth. Now let me give you an update on the PC rate environment. Rate again continued to move higher around the globe during the third quarter. Globally, it caught up nearly 7%, with tighter terms and conditions and increasingly restrained capacity. By geography, Canada is seeing the greatest rate increases, up more than 9%. The U.S. is up about 8%, followed by the U.K., including London's specialty, at about 6%, and Australia and New Zealand around 3%. By line of business, property remains the strongest, up 12%. Next is professional liability, up over 10%. Other casualty lines are up 5% to 10%, with umbrella rate increases at least twice that level. And workers' compensation is flat. So while PC rates are moving higher, the total amount of premium increases our clients are paying are more modest. This is the result of reduced exposure units, higher deductibles, lower limits, and clients opting out of coverages. Looking forward, October results are already indicating continued increases during the fourth quarter, and the carriers, in the face of catastrophe, the pandemic, rising casualty loss costs, low investment returns, are making a case for firm rates to persist. But remember, that's where we excel. Our job is to make sure our clients get a well-structured insurance program at a fair price. Regardless, it is It's certainly a more difficult market today than last quarter, and we are seeing some pockets of a hard market in certain lines and geographies. I see that continuing into 2021. Next year organic should be better than we are seeing this year play out. Moving on to mergers and acquisitions. We completed five brokerage mergers during the third 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. As I look at our M&A pipeline, we have more than 40 term sheets signed or being prepared, representing around $350 million of annualized revenues. And our pipeline continues to grow. 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. Right now, it feels like it will be a more active finish to the year as merger prospects have concerns over possible 2021 tax changes. Next, I'd like to move to our risk management segment, Gallagher-Bassett. Third quarter organic revenue at minus 5.3% was a bit better than what we said at our September IR day. This is a really nice sequential improvement from second quarter organic being down nearly 10%. And our risk management team also did a fantastic job managing its workforce and controlling costs, delivering third quarter adjusted EBITDA higher than last year by $1 million. Looking forward, we are seeing October claim counts trending similar to September. While we have experienced a steady climb out of the second quarter bottom, many clients are still operating at partial capacity and claim counts have not yet fully rebounded to last year's levels. So we're seeing fourth quarter organic revenues in our risk management segment similar or slightly better than third quarter. And just like our brokerage segment, we expect to grow our EBITDA again in the fourth quarter due to expense savings. That means we should deliver on our goal of full year 2020 adjusted EBITDA coming in better than 2019. That's just an amazing job by the team. Before I pass it to Doug, I'll finish with some comments on our bedrock culture. Despite the pandemic challenges, our global colleagues, together as a team, continue to deliver the very best service, expertise, and advice to our clients. I believe it's our unique Gallagher culture that is guiding our team through these challenging times. Specifically, I'm reminded of tenant number 20 of the Gallagher Way. We run to our clients' problems, not away from them. Since my grandfather started the company more than 90 years ago, our people have been solving problems and working hard for clients in both easier and more difficult times. And I can tell you this about our culture. It will guide us through the global pandemic. hurricanes, wildfires, and any other obstacle in front of us. Throughout Gallagher's history, we have emerged as a better, more cohesive company. I believe we will emerge from today's difficult environment stronger than ever. Okay, I'll stop now and turn it over to Doug. Doug?

Thanks, Pat, and hello, everyone. Like Pat said, another excellent quarter. I, too, would like to extend my appreciation to all of our Gallagher colleagues around the globe. What a remarkable job you are doing in these challenging times, servicing our clients, generating new business, all the while executing our cost control playbook. Today I'll begin with some comments on organic and the interplay with our cost saving. That seemed to get a lot of questions during our July earnings call and again during our September investor day call. So I'll spend a little more time on that today. Then provide a few observations from our CFO commentary document and finish with some thoughts on M&A cash and liquidity. So all right, let's go to the earnings release page four to the brokerage organic table. As Pat said, a great quarter with 4.2% all in organic, which equates to about $50 million of organic growth. Then when you turn to page six to the brokerage EBITDA table, You'll see that we grew adjusted EBITDA by $105 million this quarter. So how do we deliver that $105 million on $50 million of organic? First, about $13 million of EBITDA came from M&A net of divestitures. Next, a bid over $30 million came from that $50 million of organic. So that means we saved about $60 million from our cost control playbook. From a margin perspective, All in, we grew adjusted EBITDAG margin about 630 basis points. And then when you do the math, you'll see that even without the additional expense savings, we expanded margin about 150 basis points, which is impressive in and by itself. In the risk management segment, a little easier to compute. Revenues were backwards about 10 million, but EBITDAG grew about a million. So cost savings were about $11 million. Combine both segments, you get about $70 million of cost savings, which is at the top end of our estimates provided during our September IR day, and close to what we saved in the second quarter. Let me give you a breakdown of these savings. Reduced travel, entertainment, and advertising, down about $26 million. Reduced consulting and professional fees, down $15 million. Reduced outside labor and other workforce actions, $14 million. reduced office supplies, consumables, and occupancy costs about $11 million, and reduced employee benefit and medical plan costs about $4 million. Now, when I look towards the fourth quarter, we're starting to see a slight increase in our producers traveling more to see clients and prospects. We are executing on some targeted marketing and advertising programs, and our medical plan utilization continues to return to pre-pandemic levels. But even with that, we're still seeing savings in that $65 to $70 million range relative to last year, again, given pro forma effect for roll-in mergers. Now, moving to the CFO commentary document we post on our investor website. On page two, most of the items are consistent with what we provided to you during our September investor day. Then on page three, in total, the corporate segment came in about two pennies better than the midpoint of our September estimate. The interest and banking line, about a penny favorable. The acquisition cost line, also slightly favorable. The corporate adjusted line, that's in line with our September midpoint, and you'll also see we have a small adjustment for a one-time tax expense related to Brexit. We described that a little bit more in footnote six on that same page. Then in terms of clean energy, third quarter came in a bit better. And you'll also see our fourth quarter estimate is also a bit better. Then on page four, you'll see that we provided our first look at our 2021 estimates based on the preliminary forecasting from our utility partners. It looks like 2021 could be a lot like we're seeing here this year. And then when you get back to page 14 of the earnings release, You'll see that we have about a billion dollars of credit carry-forwards on our balance sheet at September 30. Remember, those credits are fully earned, and while we are using some currently, the big return comes between 2022 and, say, 2028, when we will use those credits and thereby harvest about $150 to $200 million of annual cash. Sure, book or gap earnings of 60 to 65 million will go away in 2022, but instead we'll have that $150 to $200 million of cash earnings in those years. As for M&A, you heard Pat say, we have a really strong pipeline. I think there could be a flurry of activity between now and year end, given what could happen with taxes. So we're really well positioned for that. We have more than $1.6 billion of liquidity consisting of available cash on hand of nearly $550 million and more than a billion dollars of borrowing power on our revolving credit facility. Okay, those are my comments. Thanks to the team for another great quarter. I think we're well positioned to pull off a terrific 2020. Back to you, Pat.