Arthur J. Gallagher & Co.

Good afternoon and welcome to Arthur J. Gallagher and Co.' 's fourth 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, including answers given in your response to questions, may constitute forward-looking statements within the meaning 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 the cautionary statements and risk factors contained in the company's 10-K, 10-Q, and 8-K filings for more details on its forward-looking 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 Mr. Jay Gallagher, Chairman, President, and CEO of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.

Thank you. Good afternoon, everyone. Thank you for joining us for our fourth quarter 2020 earnings call. On the call with me today is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. Before we get started, I'd like to make a few comments regarding the tumultuous year that was 2020. It was a year that tested everything from our physical health to our mental state of mind, to how we see one another. It has impacted our colleagues, our families, our communities around the world. It brought personal hardship and loss, stresses and challenges that none of us would have predicted a year ago. I believe we've learned a lot about ourselves and our society over the past year, and while 2020 is behind us, many issues and difficulties remain. But let's not forget 2020 also showed us that the world can work together towards a common goal to develop vaccines in order to solve a global problem. And for that, I'm both thankful and I remain optimistic about our future. Now on to the discussion of the quarter and year. We delivered an excellent fourth quarter in the midst of the pandemic. We grew organically. We picked up momentum and grew through acquisitions. We improved our productivity and raised our quality. We continued to invest in our bedrock culture. I'm extremely proud of how the team performed during the quarter and the full year. In our brokerage segment, fourth quarter, reported revenue growth was a positive 3.6%. Most of that, or 3.1%, was organic revenue growth. We executed on our cost containment playbook. and further utilized our centers of excellence, saving about $60 million in the quarter, helping drive our net earnings margin higher by 281 basis points and expanding our adjusted EBITDA margin by 579 basis points. And net earnings were up 33%, and adjusted EBITDA was up 30%. Another fantastic quarter for the brokerage team. Let me walk you around the world and give you some sound bites about each of our brokerage units, starting with our PC operations. In U.S. retail, organic growth was strong at about 4.5%. New business and client retention was similar to last year's fourth quarter, and midterm policy modifications, including full policy cancellations, were slightly better than prior year levels. In our U.S. wholesale operations, risk placement services, Organic was about 5%. Open brokerage organic was more than 20% due to strong renewals fueled by double-digit rate increases. Our MGA program's binding businesses were up about 2%. Retention was better sequentially, but as expected, new business wins are still lagging given the economy. Moving to the U.K., around 4.5% organic for the quarter. In both our retail and specialty operations, new and lost business was consistent with prior year. And special mention to our aviation team. They performed well in their largest quarter of the year, helping clients navigate exposures that were down significantly, call it 30 to 40%, and rate increases that pushed premiums close to pre-COVID levels. Australia and New Zealand combined posted organic of about 1%. The spread between new and lost business was similar to last year, but we are not getting as much lift from rate and exposure as we had in previous years. And finally... our Canadian retail operations posted organic of 13%, another terrific new business quarter combined with a nice tick-up in client retention and strong rate environment. So overall, our global PC operations posted 4.5% organic, which is a bit better than the 4% we discussed at our December investor day. Moving to our employee benefit brokerage and consulting business, fourth quarter organic was around minus 2%. which is at the favorable end of what we thought during our December IR day. Similar to the previous couple of quarters, fees from consulting arrangements and special project work were down. However, revenue from our traditional health and welfare business continues to hold up, with slightly positive fourth quarter organic, which is an encouraging sign. So when I bring PC and benefits together, total brokerage segment organic of 3.1%, a really strong quarter in this environment, and even better when you consider the tough compare against the fourth quarter 2019 of over 6%. Next, I'd like to make a few comments on the PC market, starting with the rate environment. Global PC rates continue to march higher during the fourth quarter and overall. Rate was up around 8% across our footprint. Rates in Canada led the way up more than 12%. The U.S. was up more than 8% with wholesale stronger than retail, including rate increases of 15% within our wholesale open brokerage operations, followed by the U.K., including London specialty, at about 5%, and Australia and New Zealand combined in the low single digits. By line of business, property and professional liability are up 12%, other casualty lines are up mid to high single digits, and workers' comp was flat to modestly positive. Not only are PC rates continuing to rise, terms and conditions are tightening and capacities becoming increasingly constrained for some coverages. Nearly every area and line of business is firm or firming, and there are even a few lines that are very hard, like umbrella, cyber, and public company D&O. So needless to say, it is a difficult PC environment. This is where our teams excel, helping businesses, many of which are still struggling, navigate the market through creative program design, shopping coverages, and altering programs with increasing deductibles or reduced limits to help their risk management programs fit their budgets. Looking forward, I see a similar PC market conditions continuing in 2021. And while economic growth is coming, the pace of the recovery remains uncertain. So we remain laser focused on what we can control, delivering the very best insurance and risk management advice. Now successfully doing this virtually more than ever before, constantly improving our high-quality customer service, engaging with new prospects, and growing our new business pipeline. Thus far in January, full policy cancellations and other midterm policy adjustments are trending similar to January 2020. While it's still early, we are seeing year-over-year renewal premium increases at levels comparable to fourth quarter 2020. On the benefits side, the annual enrollment season is behind us, and for many of our clients, we saw covered lives stabilize from last year's declines, while retention and new business were similar to pre-COVID levels. In addition, a few of our benefits consulting practices are seeing increased activity and engagements early on in the year. So while there's a lot of year left, These early January indications give me further conviction that full year 2021 brokerage segment organic will be even better than the 3.2% we delivered in 2020. Moving on to mergers and acquisitions. Following an active December, we finished the fourth quarter with 10 completed brokerage mergers representing about $100 million of estimated annualized revenues. And we've announced a handful more so far in January, representing an additional $85 million of estimated annualized revenues. This includes the Bollington merger in the UK, which we think will close in early February after receiving regulatory approval this week. 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 30 term sheets signed or being prepared, representing around $300 million of annualized revenues. We believe we are the platform of choice for successful entrepreneurs looking to take their business to the next level by leveraging our niche expertise, our tools and data, in addition to being a great place for their employees to advance their careers. We expect to have a very active 2021, particularly in the U.S., due to concerns related to possible tax changes. So to wrap up the brokerage segment, for the full year we delivered, 5.4% growth in revenue, 3.2% all-in organic growth, adjusted EBITDA margin expansion of 418 basis points fueled by cost savings of about $180 million, and we completed 27 mergers representing about $250 million of estimated annualized revenue. A fantastic year for the brokerage team. Next, I would like to move to our risk management segment, Gallagher-Bassett. Fourth quarter organic edged back into positive territory, nicely surpassing our December expectations of being down as much as 2%. We had some positive lift due to increasing COVID-related workers' compensation claims and saw strong retention and new business. So we ended 2020 with full-year organic of minus 2.7%. In this environment, to close a year in which core claim counts were down double digits for more than 10 months of the year, And after posting a 10% organic decline in the second quarter alone is a just terrific recovery story. Going back to April and the beginning of the pandemic, we set our sights on delivering full-year 2020 adjusted EBITDA similar to 2019. Even with full-year revenues forecasted to be down $30 million or more. And boy, did the team deliver. The team proactively managed its workforce, carefully rebalanced claim loads across adjusters, and implemented expense controls, ultimately driving 2020 adjusted EBITDA of nearly $150 million, $4 million better than 2019. Being able to grow full-year EBITDA, despite organic revenues that were backwards, is just fantastic work by the risk management team. As we look forward, January claim counts are trending very similar to the fourth quarter with many clients operating still at partial capacity. With new business sold in 2020, incepting over the next few quarters, and still room for substantial job recovery, we believe full-year 2021 organic will be closer to pre-COVID levels in the mid-single-digit range. Let me wrap up with some comments regarding our unique and resilient Gallagher culture. Culture guides our organization, our people in both good times and even more so in demanding times. And I believe culture is the source of our perseverance, our determination, and our constant push for excellence. I'm extremely proud of our collective successes during 2020, but more importantly, how we came together to work as a team, even while physically apart. Our culture has never been better, and I believe we are ending 2021 even stronger. Okay, I'll stop now and turn it over to Doug.

Doug? Thanks, Pat, and good afternoon, everyone. I'll echo Pat's comments. A great quarter and an excellent year. I, too, would like to extend my appreciation to the team. Today I'll begin with some comments on our cost savings, provide a few observations from our CFO commentary document that we post on our website. Then I'll do a vignette on our clean energy investments and finish with some thoughts on M&A cash and liquidity. All right, let's turn to the earnings release, page six, to the brokerage EBITDA table. You'll see that we grew adjusted EBITDA by about $85 million over last year's fourth quarter, resulting in about 580 basis points of adjusted margin expansion. Within that, we realized about $60 million of cost savings relative to fourth quarter 19 adjusted for May. So underlying margin expansion was about 115 basis points on 3.1% all-in organic, which on its own is impressive. When you move to page eight, management segment, we grew EBITDA at a bit more than $4 million on slightly positive organic, resulting in about 190 basis points of adjusted margin expansion. Within that, we realized about $5 million of cost savings relative to Q4-19, which was moderated just a little by new client ramp-up costs. So underlying margins were up just a bit. That, too, is excellent, given the flattish organic this quarter. Categories of fourth quarter savings for the combined brokerage and risk management segment were consistent with second and third quarter. Reduced travel, entertainment, and advertising, about $25 million. Reduced consulting and professional fees, $14 million. Reduced outside labor and other workforce savings, $16 million. Office supplies, consumables, and occupancy costs, about $10 million. So that totals around $65 million, which is consistent with what we said at our December IR day. Now, looking forward, the pace of recovery isn't clear. We came into the year with another virus surge, now maybe some positive cases coming down. Some areas are imposing more lockdowns, yet others are loosening up. There's been some successes, but mostly delays in the vaccine rollout. And now it's looking like more and more that the stimulus might be caught in gridlock here in the US. Regardless of whether you're looking at half full or half empty class, very few outlooks are expecting the business environment to be much different by the end of the first quarter. So for us, when it comes to first quarter 21, we're seeing organic in the 3% to 4% range, and we're seeing expense savings similar to fourth quarter 20. Call it another $60 million. If that happens, and we could again show margin expansion over about 500 basis points, then looking towards second, third, and fourth quarters of 21, it gets a little more tricky when you do your models because the slope of the recovery is still uncertain. And we're already realizing substantial COVID-induced expense savings beginning early in April of 20. But if the recovery steps up in those quarters and we get back to organic of, say, high 4% or 5%, it does give us a path towards holding full-year margins, especially if travel and entertainment remains limited. Now, all of this needs to be taken into context. In 2017, 18, and 19, we were expanding margins 50 to 75 basis points a year on organic in that 4% to 5% range. Then the COVID hits. We execute on our cost containment playbook. and still managed to grow organic 3%. That pops margins over 400 basis points in the face of this global pandemic. So now what I'm saying is that we have a fighting chance to hold or even improve full year margins here in 21 on the prospect of getting closer to pre-pandemic organic growth later in the year. To me, that's still about a bullish story as you could write. Now if we move to the CFO commentary document that we post on our website, on page two, blue fourth quarter column. You'll see most of the items are consistent with what we provided during our December IR day, and that's in the gray column. FX came in a penny better, and severance and integration costs also a penny better when you compare that to the prior quarters. Also on page two in the reddish column, we're now providing our quarterly look at 2021. A few comments. First, foreign exchange. With the US dollar weakening, and if it stays that way throughout the year, 2021 revenue could see $100 million tailwind in brokerage and $14 million in risk management. Wouldn't be much EPS impact within risk management, but could translate into a nickel or so for our brokerage segment. That would even be better on reported EBITDA. Talking amortization expense, we're currently forecasting a little over $100 million a quarter in brokerage, which includes all announced mergers to date. You can see the roll-in revenues associated with all announced mergers to date on page five. And then also, don't forget to adjust your amortization expense in the second and later quarters to reflect any future M&A you might be including in your model. Third, when you look at M&A multiples shown on page two on the last line of the table, like Pat said, we had an active December, closing 10, three of which were on the larger end of our typical tuck-in size. That pushed the multiple up a turn or so this year, but it's still creating a nice arbitrage to our trading multiple. More importantly, it brings some really terrific merger partners to the team, letting us grow better together over the long haul. When you move to page three of the CFO commentary in the corporate table, when you compare our December IRDA estimates in the gray column with our fourth quarter results in the blue column, we posted favorable interest expense due to strong cash flows. We had better clean energy earnings, inline M&A expense, and a slightly more favorable corporate line. Also on page three, we're now providing a first look at 21 ranges for the corporate segment, and that's in the reddish column. Nothing surprising, and there's no change on our outlook for clean energy, still in that $60 to $75 million of annual after-tax earnings we provided during our IR day. So this brings me to my vignette on clean energy. You'll read on page four, note five of the CFO commentary document, that these investments are winding down at the end of 21 unless there's an extension. That means in 2022, we will have zero gap earnings, but remember, that will be more than replaced with substantial cash flow benefits. In other words, 21 and prior years were the credit generation years when we report the gap benefit in our P&L, but 22 starts the cash harvest years where we'll get considerably larger cash benefits in our operating cash flows. Here's the shortcut way to think about how to compute those cash benefits. First, if you go to page 14 of the earnings release, about the seventh line down in our balance sheet, you'll read that we have a deferred tax asset of over a billion dollars, mostly consisting of clean energy credit carry-forwards. With one more year of credit generation, that asset should grow by another $100 million. So call it $1.1 billion of credit carry-overs by the end of 21. Then, assuming 22, we'll begin using more credits than we've been using thus far. Third, then how fast we'll be using those credits will depend on how fast we grow our U.S. taxable income. But for this illustration, and if you assume a seven-year period, it might mean we would be harvesting about $125 to $150 million in 22, with that ramping up to say about $175 to $200 million in 2028. It's a little odd that gap earnings go to zero and then the cash benefits become dramatically better, but that's just how it works. This is and has been a really important part of our story over the last decade, so I think it was worth some extra time today. All right, let me go on to some comments on cash and M&A. On December 31st, available cash on hand was nearly $700 million. We have a significant untapped capacity on our revolving credit facility. and we have another year ahead of us of really strong cash flows. That might mean that we would have perhaps up to $2.5 billion of M&A capacity here in 21. That's a terrific position as we come into a year that we see as perhaps the most active year ever in the brokerage M&A space. Okay, that wraps up 20, and we're positioned really well for 21. Organic looks better, bolt-on M&A looks better. We have a decent chance of keeping a large chunk of our cost savings. Harvesting cash flows from our clean energy initiatives. And most important, I can feel our team's excitement about coming out of the pandemic stronger than ever before. My thanks to them for another fantastic year. Back to you, Pat.