01—Abstract
Summary
Summary of the 10-K filed February 5, 2007. Cited figures are marked; the original filing is the authoritative source.
Arthur J.
Gallagher & Co. (AJG) reported 2006 total revenues of $1,534.0 milliona, up about 3% from $1,483.9 million in 2005, but net earnings rose sharply to $128.5 million ($1.31 diluted EPS) from $30.8 million ($0.32) in 2005, which had been depressed by $219.6 million of litigation, contingent commission, and claims-handling charges. Excluding those non-recurring items, 2006 earnings were materially more stable, though the company is clearly in a transition period as retail contingent commissions have been largely eliminated and the broader commercial P/C pricing market has softened. The Brokerage segment grew revenues about 7% to $1,070.7 million, driven by acquisitions (ten asset purchases and one stock purchase in 2006) and organic commission and fee growth of 6%.
Risk Management (Gallagher Bassett) grew revenues about 8% to $401.3 millionb with 8% organic fee growth. The Financial Services segment was the weak spot, with revenues falling 45% to $62.0 million and a $25.1 million net investment loss, largely tied to IRC Section 29 synthetic fuel investments, an oil-price hedge loss, and write-downs. Retail contingent commissions fell to just $2.5 million from $28.8 million in 2005, which management expects will keep weighing on pretax earnings.
Investors should weigh several risk items: the Section 29 tax credits expire December 31, 2007 absent extension and could push the effective tax rate to roughly 40-42%; the MDL settlement ($28.0 millionc to clients plus $8.9 million in attorney fees) is subject to court approval; state investigations into contingent commissions remain open; and the $1.20 dividend and share repurchases continued, with 2007 quarterly dividend raised to $0.31. Cash from operations fell to $104.7 million from $188.8 million, reflecting Headwaters and AVC-related payments.
02—Key points
Key Highlights
- Total revenues rose 3.4% to $1,534.0 million in 2006, with Brokerage up 7% to $1,070.7 million and Risk Management up 8% to $401.3 million.
- Net earnings were $128.5 million, or $1.31 per diluted share, versus $30.8 million or $0.32 in 2005, which included large litigation and contingent commission charges.
- Retail contingent commissions collapsed to $2.5 million from $28.8 million in 2005 following the company's exit from volume- and profit-based contingent commission arrangements, and management expects a continued substantial negative impact on pretax earnings.
- Financial Services revenues fell 45% to $62.0 million and the segment posted a $25.1 million net investment loss, driven by IRC Section 29 synthetic fuel investments, a $8.5 million oil hedge loss, and several write-downs.
- Organic commission and fee growth was 6% in Brokerage and 8% in Risk Management, supported by ten acquisitions completed in 2006 and additional deals announced in early 2007.
- Cash flow from operations fell to $104.7 million from $188.8 million, primarily due to $92.1 million paid to Headwaters and $26.9 million paid into the Illinois AVC fund.
- Commercial P/C premium rates continued to decline through 2006 (fourth quarter down 9.6% per CIAB data), a headwind to commission revenue that management expects to persist alongside shifts to alternative markets.
03—Questions
Frequently Asked Questions
Why did net earnings improve so much in 2006 when revenue grew only modestly?
2005 net earnings of $30.8 million were depressed by $219.6 million of pretax charges for litigation ($131.0 million), retail contingent commission matters ($73.6 million), and claims-handling obligations ($15.0 million). 2006 included only a $9.0 million contingent commission charge, so the year-over-year improvement largely reflects the absence of these non-recurring items, though 2006 also benefited from a lower effective tax rate of 16.1%.
Will the IRC Section 29 tax credits affect future results?
Yes. Section 29 credits expire December 31, 2007 unless extended. If not extended, management expects the consolidated effective tax rate in 2008 to rise to roughly 40-42%. The credits are also subject to a phase-out tied to oil prices; for 2007 the NYMEX price would need to average about $62 per barrel to begin a phase-out, and the 2007 year-to-date average was $54.23 as of January 25, 2007.
What is the status of the contingent commission litigation and regulatory investigations?
Gallagher agreed to settle the federal multi-district litigation for $28.0 million to clients plus $8.9 million in plaintiffs' attorney fees, subject to court approval, without admitting wrongdoing. The Illinois AVC fund had $8.6 million remaining at year-end 2006. Gallagher continues to face state investigations into historical business practices, and the remaining accrual is management's best estimate to resolve those matters.
Is the dividend safe, and how is capital being returned to shareholders?
Gallagher declared $1.20 per share in 2006 ($117.2 million total) and raised its first-quarter 2007 quarterly dividend to $0.31 from $0.30. The company repurchased 1.1 million shares for $31.3 million in 2006 and the board extended the buyback authorization to 5.0 million shares in January 2007. Dividends paid of $114.4 million exceeded the $104.7 million of operating cash flow, though the company has a $450 million undrawn credit facility with $432.4 million available.
What drove growth and what acquisitions were made?
Brokerage growth came from acquisitions completed in the prior twelve months ($33.7 million of commission revenue) and organic growth. In 2006 Gallagher completed eleven acquisitions for total consideration of about $116.8 million, mostly in stock and cash. Subsequent to year-end it acquired Financial Profiles, InterNational Insurance Group, and agreed to acquire Lowndes Lambert Group Canada, and it said it expects acquisitions to remain a key growth driver.
04—Continue