How significant is the end of contingent commissions for Gallagher's future earnings?

Contingent commissions were $39.5 million in 2004, of which $33.8 million came from volume- or profit-based agreements that Gallagher will stop accepting as of January 1, 2005. Management says the loss of this revenue could have a material adverse effect on 2005 results, though the company's fee-based and risk management businesses are intended to partly offset it.

What are the main legal risks facing Gallagher?

The key risks are the Headwaters case, which seeks $140 million from a subsidiary (with Gallagher counterclaiming $71 million), and broker compensation litigation, including multiple class actions and a shareholder derivative suit. Investigations by the New York Attorney General and other state regulators are ongoing. Management says the outcomes cannot be predicted.

Why did Financial Services report a loss even though its investment income increased?

Investment income rose to $173.2 million, largely from Syn/Coal installment gains and consolidated investments, but investment expenses, FIN 46-related expenses, and interest rose more, leaving a pretax loss of $9.8 million. The segment's profitability also depends on IRC Section 29 tax credits, which expire December 31, 2007, and on oil prices that affect the phase-out.

Is Gallagher's dividend safe, and how is it funded?

Dividends are supported by operating cash flow of $277.2 million in 2004 and a $250 million unsecured credit facility, with $211.9 million available as of January 19, 2005. The company declared $1.00 per share in 2004 and raised the quarterly dividend to $0.28 for 2005, which adds roughly $12 million in annual cash outflow.

What drove the growth in Brokerage and Risk Management, and is it sustainable?

Growth came from new business, renewal rate increases, and acquisitions: 19 firms were acquired in 2004 for $112.8 million in cash and stock. Organic Brokerage growth slowed to 2% as premium rates declined, so future growth will depend more on acquisitions and Risk Management fee expansion, which grew 16% organically.

AJG 10-K FY2004 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed January 28, 2005. Cited figures are marked; the original filing is the authoritative source.

Arthur J.

Gallagher & Co. (AJG) reported strong 2004 results, with total revenues rising 17% to $1,480.3 million^a from $1,263.8 million, and net earnings up 29% to $188.5 million, or $1.99 diluted EPS, from $1.57 in 2003. Growth was driven by the Brokerage and Risk Management segments, supported by 19 acquisitions in 2004 and a 16% organic fee growth rate in Risk Management. Brokerage organic growth in commissions and fees slowed sharply to 2%, from 10% in 2003, reflecting softening P/C premium rates and lost business.

Pretax earnings were also helped by Financial Services, where investment income rose substantially, largely from Syn/Coal (IRC Section 29) installment gains and FIN 46 consolidation effects. That segment's results depend heavily on tax credits and oil prices, and its management says the Syn/Coal credits could face legislative, IRS, or litigation risk. The most material risk flagged for investors is the broker compensation scandal.

Gallagher said it will stop accepting new volume-based or profit-based contingent commissions starting January 1, 2005, which could substantially reduce future contingent commission revenue (2004 contingent commissions totaled $39.5 million^b, of which $33.8 million were volume/profit-based). Gallagher faces investigations by the New York AG and other state regulators, plus multiple private class actions and a shareholder derivative suit. Separately, the Headwaters trial, which began January 11, 2005, seeks $140 million in damages from a Gallagher subsidiary tied to the synfuel business.

Management says the outcome cannot be predicted and could have a material adverse effect. Balance sheet and capital management remained solid: total assets grew to $3.24 billion^c, stockholders' equity reached $761.0 million (up from $619.1 million), there was no corporate borrowing outstanding at year-end, and $224.6 million of cash was on hand.

Cash from operations was $277.2 million^d. The company raised its quarterly dividend to $0.28 for 2005, a 12% increase, and reported $56.2 million of share repurchases in 2004.

02—Key points

Key Highlights

Total revenues grew 17% to $1,480.3 million in 2004; net earnings rose 29% to $188.5 million, and diluted EPS reached $1.99 (vs. $1.57).
Brokerage organic commission and fee growth slowed to 2% in 2004 (from 10% in 2003), reflecting softening P/C premium rates and $118 million of lost commission business.
Risk Management was the strongest operating segment, with fee revenue up 16% and pretax earnings up 40% to $60.2 million.
Management will no longer accept volume- or profit-based contingent commissions from January 1, 2005; 2004 contingent commission revenue was $39.5 million, so this change may materially reduce future revenue.
The Headwaters litigation (trial began January 11, 2005) seeks $140 million in damages against a Gallagher financial services subsidiary, which management says could have a material adverse effect if resolved unfavorably.
Financial Services pretax results were a $9.8 million loss despite $173.2 million of investment income, which depends on Section 29 Syn/Coal tax credits; the effective tax rate of about 20% relies on those credits.
Balance sheet strengthened: equity rose to $761.0 million, there were no corporate borrowings at year-end, and the quarterly dividend was raised to $0.28 for 2005.

03—Questions

Frequently Asked Questions

How significant is the end of contingent commissions for Gallagher's future earnings?
Contingent commissions were $39.5 million in 2004, of which $33.8 million came from volume- or profit-based agreements that Gallagher will stop accepting as of January 1, 2005. Management says the loss of this revenue could have a material adverse effect on 2005 results, though the company's fee-based and risk management businesses are intended to partly offset it.
What are the main legal risks facing Gallagher?
The key risks are the Headwaters case, which seeks $140 million from a subsidiary (with Gallagher counterclaiming $71 million), and broker compensation litigation, including multiple class actions and a shareholder derivative suit. Investigations by the New York Attorney General and other state regulators are ongoing. Management says the outcomes cannot be predicted.
Why did Financial Services report a loss even though its investment income increased?
Investment income rose to $173.2 million, largely from Syn/Coal installment gains and consolidated investments, but investment expenses, FIN 46-related expenses, and interest rose more, leaving a pretax loss of $9.8 million. The segment's profitability also depends on IRC Section 29 tax credits, which expire December 31, 2007, and on oil prices that affect the phase-out.
Is Gallagher's dividend safe, and how is it funded?
Dividends are supported by operating cash flow of $277.2 million in 2004 and a $250 million unsecured credit facility, with $211.9 million available as of January 19, 2005. The company declared $1.00 per share in 2004 and raised the quarterly dividend to $0.28 for 2005, which adds roughly $12 million in annual cash outflow.
What drove the growth in Brokerage and Risk Management, and is it sustainable?
Growth came from new business, renewal rate increases, and acquisitions: 19 firms were acquired in 2004 for $112.8 million in cash and stock. Organic Brokerage growth slowed to 2% as premium rates declined, so future growth will depend more on acquisitions and Risk Management fee expansion, which grew 16% organically.

04—Continue

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