Arthur J. Gallagher & Co. (NYSE:AJG) Q4 2023 Earnings Call Transcript

Arthur J. Gallagher & Co. (NYSE:AJG) Q4 2023 Earnings Call Transcript January 26, 2024

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Operator: Good afternoon, and welcome to Arthur J. Gallagher & Co.’s Fourth Quarter 2023 Earnings Conference Call. Participants have been placed on the listen-only mode. Your lines will be open for questions following the presentation. Today’s call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. The company does not assume any obligation to update information or forward-looking statements provided on this call. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially.

Please refer to the information concerning forward-looking statements and risk factors sections contained in the company’s most recent 10-K, 10-Q, and 8-K filings for more details on such risks and uncertainties. In addition, for reconciliations of the non-GAAP measures discussed on this call, as well as other information regarding these measures, please refer to the earnings release and other materials in the Investor Relations section of the company’s website. It is now my pleasure to introduce J. Patrick Gallagher, Jr., Chairman and CEO of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.

J. Patrick Gallagher: Thank you very much, and good afternoon, everyone. Thank you for joining us for our fourth quarter ’23 earnings call. On the call with me today is Doug Howell, our CFO, as well as the heads of our operating divisions. We had a strong fourth quarter to wrap up another fantastic year. All measures were right in line with what we said during our December IR Day. For our combined Brokerage and Risk Management segments, we posted 20% growth in revenue, headline 8.1% organic growth, but that’s more like 9.4% controlling for the 606 accounting and large life case timing. We also had a terrific merger and acquisition quarter. We completed 14 mergers totaling $410 million of estimated annualized revenue. GAAP earnings per share of $0.30 and net earnings margin of 2.8% were impacted by the counterintuitive earn-out payable accounting that Doug will elaborate on in a few minutes.

So, better to look at it more on a comparable basis. Adjusted earnings per share were $2.22, up 23% year-over-year, and we posted an EBITDAC margin of 30.1%, up 69 basis points over fourth quarter ’22. What a terrific quarter to close out an incredibly good year by the team. When I think about our growth for the full year, we are up 18% in revenue, that’s an increase of $1.5 billion. That’s amazing. Moving to results on a segment basis, starting with the Brokerage segment. Reported revenue growth was 20%. Organic headline was 7.2%, but I see it more like 8.7% without the accounting and timing noise, and 11% if you include interest income. Adjusted EBITDAC was $647 million, growing 21% year-over-year, and we posted adjusted EBITDAC margin expansion of 48 basis points.

Let me give you some insights behind our Brokerage segment organic, and just to level set, the following does not include interest income. Our global retail P&C brokerage operations posted organic of 8%. This includes about 8% organic in the U.S., 8% in the U.K., 5% in Canada, 10% in Australia and New Zealand. Our employee benefit brokerage and consulting business posted organic of 2% or 6%, controlling for the timing of those large life cases. Shifting to reinsurance, wholesale and specialty businesses, overall organic of 14%. This includes Gallagher Re at 12%, U.S. wholesale at 12% and U.K. specialty at 16%. So, all of these are very similar to what we were seeing throughout the year. Next, let me provide some thoughts on the P/C insurance pricing environment, starting with the primary insurance market.

Global fourth quarter renewal premiums, which include both rate and exposure changes, were up 8.5%. That’s in-line with the 8% to 10% renewal premium change we have been reporting throughout ’22 and ’23. Renewal premium increases continue to be broad-based, up across all of our major geographies and most product lines. For example, property is up 15%, even in a slow cat property quarter. General liability is up 6%, workers’ comp is up 2%, umbrella and package are each up about 10%. Shifting to the reinsurance market. 1/1 renewals were orderly reflected a more balanced supply-demand dynamic. Continued strong demand for property cat cover was met with sufficient reinsurance capacity from existing reinsurers and cat bonds. Importantly, reinsurers continue to exercise discipline on pricing and terms, not giving back the structural changes achieved last year.

In casualty, while there was adequate supply, most casualty treaties experienced pricing pressure. Specialty lines renewed mostly flattish. However, coverage limitations continued on war-related products. So, in our view, insurance and reinsurance carriers continued to behave rationally, pushing for a rate where it’s needed to generate an acceptable underwriting profit. Property is still needing rate. And more and more, we’re hearing about the need for rate in casualty lines. If prior year development turns into a big concern, we think it could be a multiyear journey of rate increases. All that said, always remember, our job as brokers is to help our clients find the best coverage while mitigating price increases. So, not all these renewal premium increases ultimately show up in our organic.

Moving to our customers’ business activity. Overall, it continues to be strong. During the fourth quarter, our daily indication showed positive midyear policy endorsements and audits ahead of last year’s levels. So, we are not seeing a slowdown. The same strength is also evident in the U.S. labor market with continued growth in non-farm payrolls and low unemployment rate, which is why I believe our HR consulting retirement and benefits business will have terrific opportunities in ’24. As we sit here today, we are very well positioned. 2023 was a great new business year, and I believe we will continue to win new clients while retaining our existing customers. We have incredible niche expertise. Our client service is top notch, and our data and analytics continues to distance ourselves from the competition.

We can handle any account of any size, anywhere around the globe. All this leads me to reaffirm that we will still see further ’24 Brokerage organic in the 7% to 9% range that would lead to another outstanding year. Shifting to mergers and acquisitions. We had an excellent fourth quarter, completing 13 new brokerage mergers, representing about $350 million of estimated annualized revenue. I’d like to thank all of our new partners for joining us and extend a very warm welcome to our growing family of Gallagher professionals. And we are off to a strong start to ’24. We’ve already closed four brokerage mergers here in January for about $30 million of annualized revenue. We also have around 40 term sheets signed or being prepared, representing around $350 million of annualized revenue.

We know not all of these will ultimately close, but we believe we’ll get our fair share, clearly, a very strong pipeline. Moving on to Risk Management segment, Gallagher Bassett. Fourth quarter organic growth was terrific at 13.2%, full year at 15.8%. Adjusted fourth quarter EBITDAC margins of 21% and full year at 20%, all this right in-line with our December expectations. We also completed one merger in Australia with expected annualized revenue of about $60 million, adding new capabilities in the disability space. Looking forward, we continue to see ’24 year organic in the 9% to 11% range and full year margins close to 20%, and that would be another outstanding year. And I’ll conclude with some comments regarding our bedrock culture. It’s a culture of client service, ethics and teamwork encapsulated in the Gallagher way.

It is an unrelenting culture of excellence that helped drive full year ’23 results for our combined Brokerage and Risk Management segments of 18% growth in revenue, of which 10% was organic. 51 mergers with nearly $900 million in estimated annualized revenue and 20% growth in adjusted EBITDAC. Most importantly, we have a culture that our people believe in, embrace and live every day. It’s a huge competitive advantage and will continue to fuel our success and growth. That is the Gallagher way. Okay. I’ll stop now and turn it over to Doug. Doug?

Douglas Howell: Thanks, Pat, and hello, everyone. Today, I’ll walk you through our earnings release commenting on fourth quarter and full year organic and margins by segment. I’ll also provide some comments on our full year ’24 outlook. We’ll then shift to the CFO Commentary document that we posted on our IR website where I’ll provide some comments on our typical modeling helpers and then give two short vignettes, one on investment income and another as a quick refresher on earn-out payable accounting. I’ll then conclude my prepared remarks with a few comments on cash, M&A and capital management. Okay. Let’s flip to Page 3 of the earnings release. Headline, fourth quarter Brokerage organic of 7.2% is right in-line with our December IR Day expectation of 7% to 7.5%.

But as Pat noted, we see that closer to 8.7% and organic of 11% if we were to also include interest income. That’s a darn good quarter, no matter what percentage you want to focus on. A couple of other puts and takes to call out on that page. First, contingents did come in a little bit better than our December thinking due to more favorable carrier performance than we thought at that time. And second, base commission and fee organic of 6.5%. That’s where you should levelize for the impact of 606 in those life cases. Controlling for those takes that over 8%. Looking ahead to ’24, our Brokerage segment organic outlook is unchanged from our late October and mid-December expectations. We still see full year organic growth in that 7% to 9% range.

All right. Let’s flip to Page 5 of the earnings release, to the Brokerage segment adjusted EBITDAC table. Adjusted fourth quarter EBITDAC margin was up 48 basis points. But remember, to get to that requires recomputing last year’s fourth quarter using current FX rates. We’ve done that in this table and is 31.3% for fourth quarter ’22. So, posting a 31.6% margin this quarter gives you that 48 basis points of margin expansion, and that’s right at the high end of our December IR Day expectation. Then, if you control for the role in Buck and other mergers we closed late in the quarter that have some seasonality, that would have been 150 basis points of expansion. That’s simply terrific work by the team. Looking ahead to next year, we anticipate seeing some full year margin expansion starting at 4% organic.

And if organic was, say, double that, maybe around 60 basis points of expansion. And note, that includes about 40 basis points of pressure against it due to the roll in of M&A, mostly Buck. On a quarterly basis, the headwind is about 80 to 90 basis points in the first quarter ’24. So, please don’t forget to reflect this nuance in your models. Okay. Moving to the Risk Management segment and the organic and EBITDAC tables on Pages 5 and 6. Another excellent quarter for Gallagher Bassett, 13.2% organic growth and margins at 21%. We continue to benefit from new business wins and excellent retention. Looking forward, even as we lap growth associated with some large new business wins from early ’23, we see full year ’24 organic in that 9% to 11% range and margins around 20%, again, that’s unchanged from our December views.

So, let’s turn to Page 7 of the earnings release and the corporate segment shortcut table. Total segment adjusted fourth quarter numbers came in a little better than the favorable end of our December IR Day expectations due to less borrowing on our line of credit and slightly lower corporate expenses. So, now let’s shift to the CFO Commentary document, to Page 3, that’s where we provide many modeling helpers. Most of the fourth quarter actual numbers are very close to our December IR Day estimates. We’ve also now added 2024 information. So, take a look at that. In particular, as we — take a look at FX. We are expecting a small headwind to EPS in the first half within the Brokerage segment. Now, moving to Page 4 of the CFO Commentary document, to the corporate segment outlook for full year ’24.

There’s no change there to our full year estimate that we provided six weeks ago during our IR Day, but we are now providing quarterly estimates. So, please take some time to refine your models with us added information. When you get to Page 5, this page shows our tax credit carryforwards. You’ll see what we discussed at our December IR Day. We are able to reestablish a portion of our tax credits following the change in tax method election when we filed our ’22 U.S. federal tax return here in the fourth quarter. Accordingly, as of December 31, we have about $870 million of tax credits available. That’s a nice future cash flow sweetener that helps us fund future M&A. So, let’s turn to the new table that we put in the top of Page 6. We thought this would be helpful as we’ve been giving a lot of questions about our investment income line.

The punchline is that this line includes items such as premium finance revenues, book gains and equity investments in third-party brokers in addition to interest income. So, this table breaks it down for you by quarter. We hope you will find this helpful. We’ve also renamed that line in our financial statements to clarify that it contains other items. No numbers change, we’ve just broadened the descriptor. So, just shifting down on that page, on Page 6, you’ll see total Brokerage rollover revenue for fourth quarter was $180 million. That’s consistent with our IR Day expectation. Looking forward, we’ve included estimated revenues for mergers closed through yesterday for the Brokerage segment in that table and for the Risk Management segment in the text below that table.

Based on Brokerage and Risk Management mergers closed through yesterday, we’re estimating around $540 million of rollover revenues to be recognized in ’24. And also, don’t forget, you’ll need to make a pick for future M&A and also add interest expense as we fund a portion of those acquisitions via future borrowings. So, while I’m on the topic of M&A, as we foreshadowed in December, we did increase our estimated earn-out payable for Willis Re during the quarter because we now have good line of sight of what we might pay out in the first quarter of 2025. Remember, the accounting for earn-out payables is a bit backwards. If expectations of performance are more favorable, it creates GAAP expense. And if expectations of performance are less favorable, it creates GAAP income.

That’s what Pat meant when he said counterintuitive accounting. That said, we do adjust these estimate changes, but were the highlight because it does create some GAAP earnings noise. The punchline on all this and what’s more important, our reinsurance business is performing extremely well. So, moving to cash, capital management and M&A funding. Available cash on hand at December 31 was about $400 million. And with another year of strong expected cash flow generation here in ’24, we estimate about $3.5 billion of capacity to fund M&A in ’24 using only free cash and incremental borrowings. So, those are my comments. As I reflect on ’23, two metrics for our combined Brokerage and Risk Management segments really sum up how good our year was: revenue growth of 18%, up $1.5 billion; and adjusted EBITDAC growth of 20% or nearly $550 million.

So, the team delivered another terrific year, and we all have tremendous momentum to do it again here in ’24. Back to you, Pat.

J. Patrick Gallagher: Thank you, Doug. And operator, I think we can go to questions now, please.

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Q&A Session

Operator: Thank you. [Operator Instructions] Our first question is coming from Elyse Greenspan with Wells Fargo. Please proceed with your question.

Elyse Greenspan: Hi, thanks. Good evening. My first question, within the 7% to 9% organic Brokerage guide for 2024, can you guys give us a sense of what you’re assuming for pricing and economic exposure throughout the course of the year?

Douglas Howell: Well, I think when we did that in our budget process, the range of 7% to 9%, it’s pretty much so what we’re seeing today throughout next year is really the assumptions. Where are we today in pricing, where are we in exposure units, what we’ve been running here this year, we don’t see a lot of change to that next year.

Elyse Greenspan: And then when you guys go through and come up with the 7% to 9%, are you assuming that all of your businesses will be in that range? I mean, now you’ve been seeing really strong growth within reinsurance, wholesale and specialty. Are those expected to continue to be above and maybe some of the others like benefits might be below? How do you see the different businesses shaking out in ’24?

Douglas Howell: All right. So on that point, not every business has given a flat target number, they view it based on what they’re seeing in the marketplace rate, exposure, opportunities, hiring, hiring new producers. So, every business does that differently. What would I say is being different? Who’s on the upper end of the range? And who’s on maybe the lower end of the range? Benefits might be a little bit on the lower end of the range, and you might see reinsurance and specialty on the upper end of the range in that. But by and large, each business unit rolls it up and that’s how we get to that 7% to 9% range.

Elyse Greenspan: And then, Pat, you mentioned some interesting comments on the casualty side. We’re starting to hear your thoughts about pricing pressure and just you said right, multiyear journey here. Can you just tell us like what you’re seeing and then how you expect this cycle could transpire assuming we do start to see more reserve holes emerge across the industry?

J. Patrick Gallagher: Well, I just think it makes some logical sense, at least. When you take a look back, we saw this in the property side. Nobody touched values for five, six, seven years because inflation was zero. And so you’ve got a bunch of reserves on the casualty side, set at those very same years that all of a sudden you come into a spike in inflation. And yes, it’s been tamped down, but it’s still there. And you look back at those reserves and then you take a look at these settlements that are, in fact, nuclear. And you start to say, well, all right, how well are those reserves going to hold up? Now look, I can’t speak for the industry as a whole. But my sense in the meetings that we’re having and discussions we’re having with a number of the various carriers is that they have some concerns there that they are not necessarily comfortable with exactly where they are.

And so, our view on that is, okay, if you take a look at if there were inflation in those numbers and if it were something where you had to get them right, you’d have to see price increases in order to do it. I don’t think that, that’s something with the kind of payout structure that you have in casualty that you need to get in one year. So, I think you’re going to see possibly affirming that does, in fact, take a few years to catch up with reality.

Elyse Greenspan: And then one last one. Have you guys reserved to the maximum on the earn-out associated with the Willis Re deal?

Douglas Howell: Effectively yes. I mean we still have to accrete that for one more year. So it might be — I think there’s $50 million of accretion that will go through the financial statements this next year.

Elyse Greenspan: Thank you.

J. Patrick Gallagher: Thanks, Elyse. Thanks for being with us.

Operator: Thank you. Our next question is coming from Mark Hughes with Truist Securities. Please proceed with your question.

Mark Hughes: Yeah, thanks, good afternoon.

J. Patrick Gallagher: Hi, Mark.

Mark Hughes: Pat, did you give the organic for open brokerage versus the program business within wholesale?

J. Patrick Gallagher: Well, I think open brokerage has been where we’ve had the real nice run-up. I mean it’s probably double to triple what’s going on in the program business. So, if you look at open brokerage that running around 13% to 15%, you’re probably looking at 5% on the programs.

Mark Hughes: And then, what’s your take on the property market? Do you think little bit of deceleration there? Well, one, do you think that’s the case? And two, would it have any kind of material impact on your organic?

J. Patrick Gallagher: I think — well, I mean, any change in pricing is going to have an impact on organic. But I’m not — no, I don’t see carriers at this point saying, “Oh, the good news is I can take the price backwards.” So, we are still seeing a push on property rate. And then you do, of course, have carriers incredibly focused on valuations. That kind of went by the wayside for years. There was no inflation, fine, 0% blah, blah, blah. Now claims are coming in, they didn’t get their premium for it, the replacement costs are substantially higher than they may be predicted. And so, I think you do have a little bit of time left where there’s going to be some valuation correction, and I do think there is a need for continued rate strengthening.

Mark Hughes: Thank you very much.

J. Patrick Gallagher: Thanks, Mark. Thanks for being with us.

Operator: Thank you. Our next question comes from the line of Mike Zaremski with BMO Capital Markets. Please proceed with your question.