Why did Gallagher's effective tax rate drop to 22.7% in 2007, and what happens next?

The low rate reflected tax credits from IRC Section 29 synthetic fuel and alternative energy partnerships, which were phased out by about 66% for 2007 and expired entirely on December 31, 2007. Management expects the effective rate to return to roughly 39-41% in 2008 and future years, which will compress after-tax earnings relative to 2007 absent offsetting growth.

How exposed is Gallagher to the contingent commission investigations and litigation?

The $28.0 million MDL settlement received final court approval in September 2007, but plaintiffs have appealed. The AVC with Illinois regulators required a $26.9 million fund, of which $8.6 million remains and is expected to be applied to the MDL obligation. Gallagher is also responding to subpoenas from New York, Connecticut and Illinois concerning its Risk Management subsidiary. The company states it cannot predict the ultimate outcome, and an adverse ruling on appeal could bring additional costs.

What drove the increase in net debt and the reduction in equity?

Gallagher borrowed $400.0 million under its Note Purchase Agreement in 2007, principally to fund $215.0 million of acquisitions and $260.8 million of share repurchases. Stockholders' equity declined to $715.5 million from $864.1 million, mainly because buybacks exceeded retained earnings growth, while the Credit Agreement was undrawn at year end with $433.1 million available.

How significant is the Financial Services segment's remaining exposure?

Financial Services contributed only 4% of revenues but carries legacy risk tied to IRC Section 29 synthetic coal facilities. Gallagher has $198.6 million of tax credits exposed to potential disallowance, with insurance providing up to $53.4 million after tax, and a maximum after-tax indemnification exposure of $287.5 million to purchasers of Syn/Coal facilities if misrepresentations are found. Management expects to divest most remaining investments in 2008, including its stake in Asset Alliance Corporation, which is part of a pending reverse merger with Tailwind Financial.

What is the outlook for organic growth given the insurance pricing environment?

Commercial P/C premium rates fell through 2007, with Lehman data showing average declines of about 11-13% per quarter in Q1-Q3 and continued declines in Q4. Because commissions track premium levels, Brokerage organic growth fell to 2%. Management is relying on new business production ($158.0 million in 2007), a shift toward fee-based compensation, and acquisitions, which added $77.2 million of 2007 revenue, to sustain growth. Risk Management, which is less tied to premium cycles, grew organic fees 11%.

AJG 10-K FY2007 Annual Report — Revenue, Net Income, EPS

01—Abstract

Summary

Summary of the 10-K filed February 4, 2008. Cited figures are marked; the original filing is the authoritative source.

Arthur J.

Gallagher & Co. (AJG) reported 2007 total revenues of $1,623.3 million^a, up 10% from $1,470.1 million in 2006, with net earnings of $138.8 million, or $1.43 diluted per share, versus $128.5 million ($1.31) a year earlier. Earnings from continuing operations rose 20% to $154.6 million. The increase was helped by acquisitions (21 deals in 2007 with $215.0 million of cash paid) and by a $9.0 million charge in 2006 that did not recur, but organic growth in commissions and fees slowed to 2%, reflecting a soft P/C pricing market in which Lehman data showed average premium rate declines of roughly 11-13% per quarter.

Results were also affected by a $15.8 million^b loss from discontinued operations, tied to the planned exit of the global reinsurance and Irish wholesale brokerage businesses. The balance sheet and capital structure changed meaningfully in 2007. Gallagher issued $400.0 million of senior notes in August 2007 (6.26% Series A due 2014 and 6.44% Series B due 2017) and used the proceeds for acquisitions and share buybacks.

It repurchased 9.2 million shares for $260.8 million^c, reducing shares outstanding to 92.0 million from 98.4 million, and stockholders' equity fell to $715.5 million from $864.1 million. The company expects its effective tax rate to rise to roughly 39-41% in 2008, because Section 29 tax credits expired on December 31, 2007, and the 2007 rate of 22.7% was flattered by those credits.

Risk factors center on the contingent commission investigations and MDL settlement (now under appeal), the cyclical soft market, the loss of the Section 29 credits, and the Financial Services segment's legacy synthetic-fuel exposure, which carries up to $287.5 million^d of indemnification risk. The Risk Management segment (third-party claims administration) grew organic fees 11%, while the Brokerage segment grew organic commissions and fees only 2%.

02—Key points

Key Highlights

Total revenues rose 10% to $1,623.3 million in 2007; Brokerage (69%) and Risk Management (27%) drove results, with Financial Services contributing 4%.
Net earnings were $138.8 million ($1.43 diluted EPS) versus $128.5 million ($1.31) in 2006; earnings from continuing operations grew 20% to $154.6 million.
Organic growth in commissions and fees was only 2% in Brokerage, while Risk Management organic fee growth was 11%, showing the impact of the soft P/C pricing cycle.
The company issued $400.0 million of senior notes in August 2007 and repurchased 9.2 million shares for $260.8 million, cutting shares outstanding 6.5% to 92.0 million.
IRC Section 29 tax credits expired December 31, 2007; management expects the effective tax rate to rise to about 39-41% in 2008 from 22.7% in 2007.
Operating cash flow rose to $252.3 million from $104.7 million, aided by the absence of 2006 litigation payments (Headwaters and AVC), though 2007 included $6.7 million of outflows linked to contingent commission matters.
The reinsurance brokerage and Irish wholesale operations were reclassified to discontinued operations after a Q4 2007 strategic review, creating a $15.8 million loss in 2007 and a planned sale in 2008.

03—Questions

Frequently Asked Questions

Why did Gallagher's effective tax rate drop to 22.7% in 2007, and what happens next?
The low rate reflected tax credits from IRC Section 29 synthetic fuel and alternative energy partnerships, which were phased out by about 66% for 2007 and expired entirely on December 31, 2007. Management expects the effective rate to return to roughly 39-41% in 2008 and future years, which will compress after-tax earnings relative to 2007 absent offsetting growth.
How exposed is Gallagher to the contingent commission investigations and litigation?
The $28.0 million MDL settlement received final court approval in September 2007, but plaintiffs have appealed. The AVC with Illinois regulators required a $26.9 million fund, of which $8.6 million remains and is expected to be applied to the MDL obligation. Gallagher is also responding to subpoenas from New York, Connecticut and Illinois concerning its Risk Management subsidiary. The company states it cannot predict the ultimate outcome, and an adverse ruling on appeal could bring additional costs.
What drove the increase in net debt and the reduction in equity?
Gallagher borrowed $400.0 million under its Note Purchase Agreement in 2007, principally to fund $215.0 million of acquisitions and $260.8 million of share repurchases. Stockholders' equity declined to $715.5 million from $864.1 million, mainly because buybacks exceeded retained earnings growth, while the Credit Agreement was undrawn at year end with $433.1 million available.
How significant is the Financial Services segment's remaining exposure?
Financial Services contributed only 4% of revenues but carries legacy risk tied to IRC Section 29 synthetic coal facilities. Gallagher has $198.6 million of tax credits exposed to potential disallowance, with insurance providing up to $53.4 million after tax, and a maximum after-tax indemnification exposure of $287.5 million to purchasers of Syn/Coal facilities if misrepresentations are found. Management expects to divest most remaining investments in 2008, including its stake in Asset Alliance Corporation, which is part of a pending reverse merger with Tailwind Financial.
What is the outlook for organic growth given the insurance pricing environment?
Commercial P/C premium rates fell through 2007, with Lehman data showing average declines of about 11-13% per quarter in Q1-Q3 and continued declines in Q4. Because commissions track premium levels, Brokerage organic growth fell to 2%. Management is relying on new business production ($158.0 million in 2007), a shift toward fee-based compensation, and acquisitions, which added $77.2 million of 2007 revenue, to sustain growth. Risk Management, which is less tied to premium cycles, grew organic fees 11%.

04—Continue

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