01—Abstract
Summary
Summary of the 10-K filed February 8, 2006. Cited figures are marked; the original filing is the authoritative source.
Arthur J.
Gallagher & Co. (AJG) reported a sharply weaker 2005 as litigation and retail contingent commission charges overwhelmed otherwise solid operating growth. Total revenues rose 3% to $1,483.9 milliona from $1,437.0 million, and commissions plus fees grew steadily, with fee revenue up about 10%. However, pretax earnings from continuing operations fell to a loss of $2.8 million from $237.3 million in 2004, driven by a $131.0 million litigation charge (largely the Headwaters settlement at Financial Services), $73.6 million of retail contingent commission related matters, and a $15.0 million claims handling obligation charge.
Net earnings dropped to $30.8 millionb, or $0.32 diluted per share, versus $1.99 in 2004. Excluding these items, management's view is that earnings per employee would have been roughly comparable to prior years, though this is a non-GAAP presentation. The more important forward-looking message for investors is the structural shift in the Brokerage business.
Gallagher stopped accepting volume-based or profit-based contingent commissions from retail clients effective January 1, 2005, and under the May 2005 Illinois Assurance of Voluntary Compliance it will not accept U.S. retail contingent compensation going forward. Management expects contingent commission revenue to decline substantially, which it says will weigh on pretax earnings beginning in 2006, while the new compensation model is still in early stages with no assurance it will replace lost revenue. Organic commission and fee growth was only 2%c in Brokerage in 2005, and roughly 4% overall once the Risk Management Segment is included.
Balance sheet and liquidity remain sound: no corporate borrowings were outstanding at year-end, cash and equivalents were $317.8 milliond, the $450 million credit facility was undrawn, and stockholders' equity was $769.1 million. Cash flow from operations fell to $188.8 million, reflecting the Headwaters and AVC payments. Investors should also weigh continuing exposure in the Financial Services segment, where Section 29 synthetic fuel tax credits expire at the end of 2007, oil-price phase-out risk could curtail operations, and numerous contingent commission lawsuits and state investigations remain pending.
02—Key points
Key Highlights
- Total revenues grew 3.2% to $1,483.9 million in 2005, led by Risk Management fees up 7% and Brokerage commissions and fees up roughly 8-16%, driven partly by acquisitions.
- Pretax earnings from continuing operations swung to a $2.8 million loss versus $237.3 million profit in 2004, primarily due to $131.0M litigation charges, $73.6M retail contingent commission matters, and $15.0M claims handling obligations.
- Diluted net earnings per share fell to $0.32 from $1.99; earnings from continuing operations per diluted share were $0.30 versus $2.00.
- Retail contingent commissions were eliminated for new business from January 1, 2005 and restricted under the Illinois AVC; management expects a substantial negative impact on pretax earnings beginning in 2006.
- Organic commission and fee growth slowed to 2% in Brokerage and 7% in Risk Management, with the Brokerage new-compensation model still in early stages.
- Balance sheet remains conservative with no corporate borrowings, $317.8M cash, $417.8M available under the $450M credit agreement, and $769.1M stockholders' equity.
- Dividend raised to $0.30 quarterly for 2006 (from $0.28), and 2005 dividends declared totaled $1.12 per share; the company also repurchased no shares in 2005.
03—Questions
Frequently Asked Questions
Why did Gallagher report a loss before taxes in 2005 when revenues grew?
Revenues increased 3% to $1,483.9 million, but total expenses rose to $1,486.7 million because of three non-recurring-type charges: $131.0 million of litigation-related matters (mainly the Headwaters settlement and related costs at the Financial Services segment), $73.6 million for retail contingent commission matters tied to regulatory and private litigation, and $15.0 million of claims handling obligations for reinsurance brokerage clients. Excluding these charges, pretax earnings would have been roughly $285 million.
How much will the end of contingent commissions hurt future earnings?
Management has said contingent commission revenue, which was $35.2 million in total for 2005 and $28.8 million from retail sources, will continue to decline substantially. It expects this reduction to have a substantial negative impact on pretax earnings beginning in 2006. The company is relying on a new business compensation model, fee-for-service arrangements, and growth in risk management and captive services, but it provides no assurance these will fully replace the lost revenue.
What are the main remaining legal and regulatory risks?
Gallagher faces a purported class action in Cook County, Illinois over undisclosed contingent commissions, a multi-district litigation proceeding in New Jersey with multiple similar class actions, several state attorney general and insurance department investigations, and a New York AG subpoena to its Gallagher Bassett unit. The $26.9 million Illinois AVC payment resolved the Illinois state investigations, but management says outcomes cannot be predicted and that adverse results could materially affect cash flows.
What risks exist in the Financial Services segment?
The segment's results depend heavily on Section 29 synthetic fuel tax credits, which expire December 31, 2007 if not extended. Oil prices above phase-out thresholds (roughly $60 to $74 per barrel NYMEX for 2006) could curtail operations and trigger an estimated $18 million impairment if facilities are idled. The segment also carries indemnification exposure from prior partnership sales and ongoing IRS audits and congressional scrutiny of synthetic coal credits. Management projected a 2006 pretax loss of $20 to $25 million if operations continue.
04—Continue