Arthur J. Gallagher & Co. (NYSE:AJG) Q3 2023 Earnings Call Transcript

Arthur J. Gallagher & Co. (NYSE:AJG) Q3 2023 Earnings Call Transcript October 26, 2023

Operator: Good afternoon, and welcome to Arthur J. Gallagher & Co.'s Third Quarter 2023 Earnings Conference Call. [Operator Instructions]. 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 securities laws. The company does not assume any obligation to update information or forward-looking statements provided on this call. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the information concerning forward-looking statements and Risk Factors sections contained in the company's most recent 10-K, 10-Q and 8-K filings for more details on such risks and uncertainties.

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 Patrick Gallagher, Jr., Chairman, President and CEO of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.

A smiling couple walking hand-in-hand out of a modern insurance office, illustrating the company's commitment to its customers.

Patrick Gallagher: Good afternoon. Thank you for joining us for our third quarter '23 earnings call. On the call with me today is Doug Howell, our CFO, as well as the heads of our operating divisions. We had an excellent third quarter. For our combined brokerage and risk management segments, we posted 22% growth in revenue, 10.5% organic growth; GAAP earnings per share of $1.72, adjusted earnings per share of $2.35, up 22% year-over-year, reported net earnings margin of 15.5%, adjusted EBITDAC margin of 30.8%, up 78 basis points. We also completed 12 mergers totaling $57 million of estimated annualized revenue. Another great quarter by the team on all measures. Before I dive into more detail about the quarter and our outlook, I want to make a comment regarding the leadership appointments that were also announced this afternoon.

Tom Gallagher will assume the role of President, and Patrick Gallagher will become COO, both effective January 1, 2024. These appointments are being made to better position us for the next phase of our growth. And before you ask, I have no plans to retire. I will continue to be CEO and Chairman focused on Gallagher's strategy and global expansion. In their future roles, Tom and Patrick will help me lead organic and merger and acquisition growth initiatives, drive operational improvement and further promote our bedrock culture across the entire organization. This is the best business on the planet. I love my job and believe we are just getting started. Moving to results on a segment basis. Let me give you some more detail on our quarter's performance.

Starting with the Brokerage segment. Reported revenue growth was 22%. Organic was 9.3%. Acquisition rollover revenues were $153 million. Adjusted EBITDAC growth was 23%, and we posted adjusted EBITDAC margin expansion of about 55 basis points. Let me walk you around the world and provide some more detailed commentary on our brokerage organic. And just to level set versus some of our peers, the following figures do not include interest income. Starting with our retail brokerage operations. In our U.S. P/C business underlying organic growth was about 8%. New business production and retention was better than last year, while less nonrecurring construction and capital markets business was a bit of a headwind. Our U.K. P/C business posted 7% organic with new business production and retention similar to last year.

Our Canadian P/C operation was up 10% organically, reflecting solid new business and retention and more modest renewal premium increases. Rounding out the retail P/C business, our combined operations in Australia and New Zealand posted 13% organic. Core new business wins remain excellent, and renewal premium increases were ahead of third quarter '22 levels. Our global employee benefit brokerage and consulting business posted organic of 6% with solid health and welfare results and continued strength across many of our retirement and HR consulting practice groups. Shifting to our reinsurance, wholesale and specialty businesses. Gallagher Re posted 20% organic, thanks to a strong 7/1 renewal season, another outstanding quarter by the team following an excellent first half.

Risk Placement Services, our U.S. wholesale operations posted organic of 7%, including a couple points headwind from lower contingents. Open brokerage organic was 13% and organic was about 5% in our MGA programs and binding businesses. And finally, U.K. Specialty posted organic of 18%, benefiting from outstanding new business production, strong retention and continued firm market conditions. Next, let me provide some thoughts on the P/C insurance pricing environment, starting with the primary insurance market. Global third quarter renewal premiums, which include both rate and exposure changes were up 10%. That's at the top end of the 8% to 10% renewal premium change we had been reporting throughout '22 and early '23 and very similar to second quarter renewal premiums adjusting for business mix.

Renewal premium increases remained broad-based, up across all of our major geographies and most product lines. For example, property is up more than 20%. General liability is up about 6%. Workers' comp is up about 2%. Umbrella and package are each up about 10%. Overall, the primary market continues to behave rationally in our view, with carriers pushing for rate where it's needed to generate an acceptable underwriting profit. Remember, though, our job as brokers is to help our clients find the best coverage while mitigating price increases. So not all of these premium increases ultimately show up in our organic. Shifting to the reinsurance market. Following the orderly July 1 renewal season, all eyes are turning to January renewals. Assuming no major cat events before year-end, we believe the property reinsurance market will see adequate capacity, continued firm pricing, rising insured values and increased demand overall.

When it comes to casualty, reinsurers appear to be taking a cautious view of risk. With that said, we believe adequate capacity will be available to support increased demand at firmer pricing. Here in the U.S., our retail and reinsurance teams met with more than 25 of our key U.S. insurance carrier partners at the annual CIAB conference earlier this month. It remains a tough environment for carriers, dealing with frequency and severity of weather events, including secondary perils, pockets of unfavorable prior year development in casualty lines, higher replacement costs, social inflation and rising reinsurance costs. So we believe carriers are likely to seek out further renewal premium increases and to maintain their cautious underwriting posture.

Moving to our customers' business activity. Overall, it continues to be more resilient than headlines would suggest and we continue to characterize it as strong. During the third quarter, our daily indications showed year-over-year increases in positive midyear policy endorsements and audits. Additionally, the U.S. labor market remains strong. With continued growth in U.S. nonfarm payrolls and a wide gap between the amount of job openings and the number of people unemployed and looking for work. We also just passed the 6-month mark of the Buck acquisition, and the team is off to a fantastic start with integration on track and financial performance in line with our expectations, and I am most pleased with how the teams have come together to better serve our clients.

So I believe our HR Consulting, Retirement and Benefits business is well positioned headed into the 2024 enrollment period. So bringing it all together, as we sit here today, we see full year brokerage organic in the upper 8s and pushing towards 9%, posting that would be another fantastic year. Let me move on to mergers and acquisitions. We had an active third quarter, completing 12 new tuck-in brokerage mergers representing about $57 million of estimated annualized revenue. I'd like to thank all of our new partners for joining us and extend a very warm welcome to our growing Gallagher family of professionals. We also recently signed definitive agreements to acquire the insurance brokerage operations of Eastern Bank and Cadence Bank, with total pro forma annualized revenue towards $275 million.

Building on our success from the 2022 M&T Bank transaction, we are extremely excited about these mergers and believe these 2 regional banks have built brokerage businesses that operate and feel a lot like us. And if that isn't exciting enough, we also have a very strong merger pipeline. Excluding these 2 pending mergers, we have around 45 term sheets signed or being prepared, representing more than $450 million of annualized revenue, and we know all of these won't ultimately close, but we believe we'll get our fair share. Moving on to our Risk Management segment, Gallagher Bassett. Third quarter organic growth was 17.9% ahead of September expectations due to continued growth in claim counts and new business from 22 new business wins. We still expect to grow over these wins by double digits during the fourth quarter due to our superior client offerings, some smaller new business wins in '23 and continued growth in claim activity.

Third quarter adjusted EBITDAC margin of 20.4% was strong and in line with our September expectation. Looking forward, we see full year '23 organic above 15% and adjusted EBITDAC margins pushing 20%, and that would be another fantastic year. And I'll conclude with some comments regarding our bedrock culture. A few weeks ago, I had the pleasure to visit our associates in our India Gallagher Center of Excellence. It was awesome to see our team in action again. The energy, the excitement and relentless pursuit of improvement is thriving among our 10,000 colleagues. It's a huge competitive advantage for us because we can take a process, streamline and standardize it and then move it to our centers of excellence. Once there, the process is refined even further, and then we make the service available to all our geographies.

At the same time, we are refining, automating, deploying robotics and using AI. We are a machine that is driving out rework, improving turnaround times and raising our quality. And remember, we don't outsource these important roles. Rather, these full-time Gallagher employees represent the very best service and support professionals who are passionate about our customers and have a culture of constant improvement, which is the Gallagher way. Okay. I'll stop now and turn it over to Doug. It was a great quarter. Doug, over to you.

Douglas Howell: All right. Thanks, Pat, and hello, everyone. Today, I'll walk through third quarter organic and margins by segment, make some comments about how we see the fourth quarter shaping up and provide some early thoughts on full year '24. Then I'll provide some comments on our typical modeling helpers using the CFO commentary document that we posted on our website, and I'll conclude my prepared remarks with a few comments on cash, M&A and capital management. Okay, let's flip to Page 3 of the earnings release. All-in brokerage organic of 9.3% which, as a reminder, does not include interest income like some of our peers report. Organic, including interest income would be about 12%. A few soundbites: first, in total, we came in a little bit better than we foreshadowed at our September IR Day due to really strong results from reinsurance and London specialty; second, base commission and fee organic was strong at 9.6%; third, supplementals and contingents, together up 5%.

At our IR day, we flagged some softness, mostly related to the Maui fires. Since then, we have also seen a very slight uptick in expected insurance carrier loss ratios that also had a modest unfavorable impact to organic. Regardless, 9.3% in total without interest income, 12% with, both are fantastic results for the quarter. One special mention. Pat discussed that global renewal premium increases, we were seeing around 10% this quarter. And on the surface, it might appear this increase is a bit lower, maybe about a point from what we said in September and also from second quarter. It's important to note, when we look at our data by line and customer and then adjust for mix, the renewal premium increases for the third quarter are very similar to second quarter.

So please don't interpret that there has been any meaningful shift in the market. We're just not seeing that. Looking ahead to Q4 organic. Over the last year, we have reminded that we have an accounting headwind to overcome. Recall in Q4 '22, we booked a change in estimate related to our 606 deferred revenue accounting. That will now create a more difficult compare, called out about a point of organic headwind. Again, no new news here, but just a reminder as you update your models. Controlling for this, we see fourth quarter underlying organic growth approaching 9%, but the headline might look more like 8%. If we post that, that would mean full year brokerage organic in the upper 8s pushing towards 9%. Again, these percentages do not include interest income.

What a great year that would be. Flip now to Page 5 of the earnings release to the Brokerage segment adjusted EBITDAC table. We posted adjusted EBITDAC margin of 32.4% for the quarter. That's up 55 basis points over third quarter '22's FX-adjusted margin. That's great work by the team to end up a bit better than our September IR Day expectations. Looking at margins like a bridge from Q3 '22, organic gave us 80 points of expansion. Incremental interest income gave us 90 basis points. All-in M&A, mostly Buck which naturally runs at lower margins, impacted it by about 65 basis points. We also made incremental technology investments, called out about $7 million, and had some continued inflation on T&E, called out about $3 million, which in total used about 50 basis points.

Follow that bridge and the math gets you close to that 55 basis points of FX adjusted margin expansion in the third quarter. As for adjusted EBITDAC margin outlook for the fourth quarter, we expect about 40 to 50 basis points of expansion. And remember, that's off of fourth quarter '22 margins recomputed at current FX levels. However, unlike the past few quarters where FX created some noise, we're fortunate that now there's not much impact to consider, so much easier to model. If we deliver on that full year '23 which show margins expanding 30 to 40 basis points or 80 to 90 basis points levelizing for the roll-in impact of Buck, that would be a terrific year. Looking ahead to next year, we are just beginning our budgeting process. And -- but our early -- very early thinking is that organic -- we're seeing organic in that 7% to 9% range.

As for margins, we would anticipate seeing some margin expansion starting at 4% organic growth and perhaps if we hit 7%, call it around 50 basis points of expansion. And also, one other modeling heads up, please don't forget, first quarter '24 margins will have a slightly tougher year-over-year compare since Buck will still be rolling into our results. Okay. Let's move on to the Risk Management segment and the organic and EBITDAC tables on Page 5 and 6, a really strong finish to the third quarter. 17.9% organic growth and margins at 20.4%. As Pat mentioned, we continue to benefit from higher claim counts related to the new business wins from the second half of '22. Looking forward, we see organic in the fourth quarter around 13% and margins just above 20%.

Organic does reflect the lapping of last year's newer large business wins and margins remain terrific. So if we deliver on that, full year organic would be above 15% and margins pushing 20%. That would be another record year for Gallagher Bassett. Looking ahead to full year '24, our early thinking is pointing towards 9% to 11% organic and margins around 20%. Okay. Let's turn to Page 7 of the earnings release and the corporate segment shortcut table. In total, adjusted third quarter came in $0.03 better than the midpoint of the range we provided during our September IR day. Two reasons: first, lower borrowings on our line of credit and some of the M&A opportunities were pushed into October and November and second, lesser FX remeasurement headwinds.

Let's move now to the CFO commentary document to Page 3. A couple of things versus our September IR Day estimates. You'll see third quarter amortization expense is better by $7 million. But remember, this is noncash and doesn't impact adjusted EBITDAC nor adjusted EPS. This was simply due to balance sheet true-ups when we get our third-party M&A valuations. Then you'll also see depreciation is a touch higher by $2 million, but that is offset by change in acquisition earn-outs, which is lower by $2 million, so no net impact there. Looking ahead, we've updated our fourth quarter numbers and footnotes, so just do a double check of your models. And we will also update this page again during our December IR Day and give you a first look at 2024 numbers.

Flip over to Page 4 of the CFO commentary document to the corporate segment outlook for the fourth quarter. Only real movement is that Q4 interest and banking expense is up a bit, reflecting more anticipated borrowing. Moving to Page 5. This is the page that shows our tax credit carryforwards. As of September 30, we have about $670 million available, a nice future cash flow sweetener that helps fund future M&A. When you turn to Page 6, you'll see the rollover revenue table for third quarter -- the rollover revenues for the third quarter were $153 million, that's a little better than our IR Day expectation, mostly due notably to 1 merger that really hit it out of the park during the second half of September. It really shows you the potential upside mergers can see after joining Gallagher.

Looking forward, we have included estimated revenues for M&A closed and announced through yesterday. That's important to note these numbers already include expected revenues from Eastern and Cadence. We've assumed a mid-fourth quarter closing date, so please don't double count. And also, as we always say, please don't forget, you need to make a pick for future M&A also. In terms of funding M&A, first, available cash on hand at September 30 was around $550 million. Second, our fourth quarter is historically a very strong cash flow quarter. Third, we currently have nothing outstanding on our line of credit, so we can use that or do a bond offering. And finally, if we close a lot of the tuck-in M&A pipeline that Pat discussed, before year-end, we may use a small amount of stock, but call it a couple of hundred million dollars.

As we consider these alternatives, we're always being very mindful of maintaining our solid investment-grade rating also. As for 2024, we are currently estimating about $3.5 billion of capacity to fund future M&A using only free cash and incremental borrowings. Okay. Those are my comments, another fantastic quarter by the team. It's looking like another fantastic year. Congratulations to Patrick and Tom on their new roles. We have terrific momentum taking us into '24. Back to you, Pat.

Patrick Gallagher: Okay. I think we're ready for some questions and answers. Operator, will you open it up?

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