The Good, The Bad, and The Ugly - AJ Galagher

April 29, 2005 - Minyanville

As “the Ugly” and “the Bad” dominated the performance for Arthur J Gallagher & Co (AJG) this quarter, at least on the surface, and as such we will address them first:

The Ugly:

• Only 4% of the 12% revenue growth was organic, the rest came from acquisitions.
• In the brokerage segment, organic revenue growth was only 1%. Though the organic growth looks awful, it is largely a reflection of softening of the insurance market. The volumes (number of contracts) are increasing; the dollar amount of transactions is declining. On the glass half full side of the equation, customers are increasing their coverage as the same dollar amount now affords them a better coverage (i.e. lower deductible and/or larger policy). This should mitigate some of the weakness in sales caused by a decline in premiums. The big question is when?
• Operating margins contracted by 3% versus the first quarter last year. It was driven by: 1.3% due to new hires, 1.2% increases in stock options and medical expenses. Where is the other 0.50%? (don’t know). Margin compression – we have seen it before - AJG simply grows out of it. That is what I truly like about AJG’s management. They are not managing the business for the short-term. As much as it pains Wall Street, AJG’s management is indifferent to the whims of the quarterly-oriented analysts. Margins are likely to come back to their normal levels in the future. Also, the first quarter is usually seasonally the weakest for AJG, thus margins will improve gradually throughout the year.
• AJG lost a $175 million breach of contract lawsuit with Headwaters. This is a very significant amount for AJG. AJG has a very strong balance sheet (no net debt) and ample cash flows. AJG is selling some of its non-core assets to pay for that lawsuit, in the short run it may have to tap into a line of credit to pay the $175 million (the actual net payment will be less after taxes). This large sum will not hinder either current or future growth. The only consequence that I can think of, could be AJG postponing some of the stock buy back. AJG will appeal that ruling, so $175 million payout is not a certainty, at least not just yet.

The Bad:

• AJG took a charge of $35 million to reserve for possible settlements on contingent commission issue with different states. Actually once these settlements are reached it will be very good news for the stock, since it is another uncertainty that is hovering over the stock.
• The end of contingent commissions. As of January 1, 2005, AJG stopped putting a contingent commission clause into their contracts. However, they will be collecting contingent commissions for contracts that were written last year. Contingent commissions only accounted for $20 million, a small portion of revenues, thus their disappearance will not be as painful for AJG as it is for other brokers. However, gradual winding down of contingent commission should have a negative impact on the bottom line, since they carry a very high profit margin. On the positive side, in the long run insurance brokers (including AJG) will likely recoup the contingent commission fees through rate increases.

The Good:

• AJG’s Gallagher Basset division showed very respectable revenue growth of 13%, all of which was organic. In addition, margins expanded 4% fueling 27% of earnings growth. This business segment is somewhat sensitive to the economy, especially to the employment level as Gallagher Basset administers a lot of worker compensation claims.

Growth by acquisition. Usually I am not jumping up and down when a company’s growth strategy is based on acquisitions. Organic growth is usually less risky and cheaper and thus more valuable to shareholders. That being said, AJG’s acquisition strategy makes sense, especially in the soft insurance market, since AJG can buy companies at lower prices. Acquisitions are never large, it buys small brokerage firms whose corporate culture has a good fit with AJG (very important for acquisitions to work). And instead of trying to fully integrate them (usually a source of problems in an acquisition) AGJ helps them grow faster and more profitable buy linking them into its existing network and increasing the acquired companies’ product offering.

Though the bulk of revenue growth in the current quarter came from acquisitions the balance is likely to shift back to organic growth as the insurance market stabilizes. This quarter was riddled with a lot of one-time items, an unusual development for AJG. Between softening of the insurance market, the contingent commission controversy, losing of a very large lawsuit, contracting of margins – there was not much to like in this quarter. Patience is required in this juncture. However, all the bad news appears to me to already be priced into the stock (not advice). The Headwater issue is fully reflected and may only get better (at least not worse) if it gets overturned on the appeal. There is some risk that actual settlements with the states will be higher than $35 million reserved by AJG. However, knowing AJG management, it is likely to err on the side of caution. In addition, Aon (AOC) which is eight times larger than AJG set a reserve of $50 million. AJG’s valuation appears very appealing. At 14 times this year’s earnings, 11 times free cash flows and a super nice 4% dividend yield – this stock looks very attractive to me (again not advice). Our discounted cash flow model puts the valuation of the stock a lot higher. There is plenty of room for valuation expansion, AJG doesn’t have to do anything heroic in terms of earnings growth to deliver a decent total return, since it already pays a nice dividend. On the surface, the growth in earnings doesn’t appear around the corner, at least after looking at current quarter numbers. I believe it is. In the short-run, growth may be mitigated somewhat by the winding down of contingent commissions, however, as I mentioned above, AJG is likely to recoup that loss by charging a higher brokerage fee. Vitaliy N. Katsenelson, CFA Copyright Minyanville.com