Good morning, and welcome to the Arthur J. Gallagher & Co.'s fourth quarter 2016 earnings conference call. Participants have been placed on a 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, including answers given in response to questions, may constitute forward-looking statements within the meanings of the securities laws. These forward-looking statements are subject to certain risks and uncertainties that will be discussed on this call, and which are also described in the Company's reports filed with the Securities and Exchange Commission. Actual results may differ materially from those discussed today.
In addition, for reconciliations of the non-GAAP measures discussed on this call, as well as other information regarding the use of these measures, please refer to the most recent earnings release and the other materials in the investor relations section of the company's website. It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President, and CEO of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.
Thank you, Dana. Good morning, everyone, and thank you for joining us for our fourth quarter 2016 earnings call. With me this morning is Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. As we do each quarter, today Doug and I are going to touch on the four key components of our strategy to drive shareholder value. Those are, number one, organic growth. Number two, growing the business through mergers and acquisitions. Number three, improving our productivity and quality. Fourth, maintaining our unique Gallagher culture. The team executed on all four this quarter and for the entire year. I believe we're well-positioned to build upon 2016's success. I am very pleased with how the year turned out. Let me talk first about brokerage organic growth. Fourth quarter organic growth was 3.6% all in, right in line with our full year result.
Domestically, we saw about 3.5% organic growth in the fourth quarter, with retail property casualty up a little more than 3.5%, and wholesale and benefits up a little less. Property casualty rates continue to be a slight headwind, offset somewhat by exposure growth. Combined rate and exposure reduced our domestic PC brokerage organic by about a point. Internationally, brokerage organic growth was 3.7%. Australia and New Zealand were up over 4%, Canada up 2%, and our U.K. and Bermuda operations up around 4%, and this is in spite of rates that were softer internationally. This is great work by our domestic and international teams and highlights our outstanding sales and service culture that does make Gallagher so unique. Our global PC brokerage businesses are working well together, and our niche focus continues to provide clients with the highest quality advice, insights, and solutions.
Combine that with our outstanding post-sale service, it's easy to see the tremendous value we are providing our clients. Our employee benefits business is perfectly positioned to help our clients navigate perhaps their most difficult challenges: how to attract and retain competitive workforce, also control their total benefit costs. We recently published a survey of over 3,000 companies, we have expertise and resources very well aligned to help them navigate an uncertain and rapidly changing healthcare industry. To wrap up my organic comments, when I look forward, I'm seeing an environment much like 2016. Right now, 2017 organic feels like it will be similar to 2016. Let me move to merger and acquisition growth. We completed nine acquisitions this quarter at fair multiples, representing about $40 million of annualized revenue.
Merger and acquisition activity during the second half of 2016 was a little slower than normal as several sellers chose to close in early 2017 in hopes of tax reform. This is why we've already closed five mergers for about $32 million of revenue here in January. Normally, we see a lull in activity during the first quarter, that has not been the case so far in 2017. Our merger and acquisition pipeline remains robust with about $200 million of revenues associated with about 40 term sheets either agreed upon, issued, or being prepared. Not all these transactions will close, I feel good about our ability to attract acquisition partners in our typical small tuck-in size at fair prices. Our merger partners see our vast capabilities, believe in our unique culture, realize they can be more successful together.
I would like to thank all of our new partners for joining us, I extend a very warm welcome to our growing Gallagher family of professionals. How did we do for the year in our brokerage segment? 9% total adjusted revenue growth, of which 3.6% is organic. Adjusted EBITDA growth of 11%. Adjusted EBITDA margin was 26.9%, expanding 43 basis points from 2015. For the past three years, we've posted over 3.5% annual organic growth and expanded adjusted EBITDA margins every year. I'd have to give it to the brokerage team. That's three years in a row of really awesome performance. I would like to move to our risk management segment, which is primarily Gallagher Bassett. Fourth quarter organic growth was 2.9%, a nice improvement from our third quarter year-to-date results.
Adjusted EBITDA margins expanded 42 basis points to 17.9%, as our expense discipline allowed us to beat our margin expectation of 17.2% for the quarter. For the year, we delivered positive organic and were able to expand our adjusted EBITDA margin by a few basis points. Taken in the context of the headwinds from claim count growth and lower international performance bonus fees, I feel these results were really good results. Going forward, we believe our 2017 organic growth will show improvement over 2016 as net new business wins fully make their way into our results and performance bonus fees rebound. We have an outstanding differentiated value proposition, we believe we can continue to deliver superior claim outcomes and help our clients manage and mitigate their total cost of risk. Moving to clean energy. Nearly $115 million of net after-tax earnings.
What an amazing run since 2011, when we posted just $4 million of net earnings. You'll hear Doug talk about another step up in 2017. Finally, our culture. This year marks our 90th anniversary, and we continue to work very hard to ensure that 90 years of building a rock-solid foundation of ethics and culture is not just lip service. We believe it, we embody it, we promote it every day. For the last five years running, we've been recognized as one of the world's most ethical companies by the Ethisphere Institute. I think a great quarter, an excellent year, I'll stop now and turn it over to Doug. Doug?
Thanks, Pat, good morning, everyone. Like Pat said, what an excellent way to close out a terrific year. Today, I'm going to provide my typical commentary on modeling, margins, clean energy, cash capital management, I'll close with some comments on tax reform. First, to the CFO commentary document, which is posted on our investor website. Let me point out a few items as you model 2017. First, we've provided our guess on the impact from foreign currency exchange rates on both revenue and EPS. Based on current FX rates, we expect some brokerage segment revenue headwinds in the first half of 2017, but not much in the second half, which translates into a couple pennies a quarter of EPS impact in the first and second quarter, but again, not much in the second half.
When modeling 2017 brokerage revenues, you should first adjust prior year revenues for the impact of FX and then apply your pick for organic growth. You should then add your estimate for rollover M&A revenues that we've completed in 2017 and thus far in 2016 and thus far in 2017. We give you our estimate on page five of the CFO commentary. You should then make a pick for new M&A revenue that might come from future mergers in 2017. Also remember to assume a mid to late quarter closing pattern. If you model revenues in this order, it should get you pretty close. When doing your quarterly models, please don't forget that we have significant quarterly seasonality in our brokerage segment.
Best place to see that is on page five of the supplemental quarterly financial document we also post on our investor website. You'll see that we historically earn about 20% of our brokerage segment annual earnings in the first quarter, then about 30% in the second, then about 25% in the third and the fourth quarters. As for the risk management segment, we really don't have that much seasonality other than performance bonus income. All right. Let me move on to margins. Adjusted brokerage EBITAC margin expanded 31 basis points in the quarter. That's great work by the team as we continue to focus on quality and productivity improvements across our global brokerage business. Please remember, expanding margins if organic is below 3% is very difficult to do.
We're basically finished with integrating our large brokerage mergers from 2014, other than some small projects internationally. Integration costs in 2017 should only be about a penny a quarter, which is in line with our initial thinking from our December investor meeting. I'm extremely proud of the folks for posting solid organic growth, even while pulling double duty working through integration. Moving to the risk management segment. Adjusted EBITAC margin of 17.9% was above our expectation of 17.2%. This is really good work by the team and shows excellent discipline in our cost control efforts. Looking towards 2017, we still expect our risk management margins to push towards 17.5% for the full year. Finally, I hope you enjoyed hearing from our Global Chief Customer Service Officer at our December investor day.
Don't forget, we've made truly amazing progress in improving our service quality and our productivity here in the U.S.A. and also in London. We know that those learnings can help deliver similar success elsewhere in the U.K., as well as Canada and Australia. Said, it will take a lot of hard work here in 2017 to be able to start realizing the benefits in 2018. Moving to clean energy. We had a solid fourth quarter, and for the year, we delivered on our expectations of about 15% earnings growth. Looking towards 2017, you'll see on page three of the CFO commentary that the midpoint of our range for 2017 clean energy net earnings would be about another 10% step up over 2016.
Don't forget, we have about $480 million of credits on our balance sheet, $480 million of credits on our balance sheet, which is effectively a receivable from the government that will help us reduce our future cash taxes paid for many years to come. As for cash, we have about $225 million of available cash, and we continue to unlock cash from our bank account consolidation efforts. As I look towards 2017, two cash headwinds, integration, as I discussed earlier, and building our new home office building are practically behind us. You'll see in the CFO commentary that we'll have some one-time move and lease termination charges in 2017 as we move our headquarters. Other than that, it's all behind us. As for stock, we used about 100,000 shares in M&A this quarter, recall, we pre-bought those shares mid-year. How do we do for the year?
We issued just under 2 million shares for mergers during 2016, and we bought back 2.3 million shares. Net down about 300,000 shares related to M&A this year. Thus far in 2017, we haven't used any shares, and as I look at our 2017 cash flow projections, we think that we can fund deals with cash and debt. Finally, some comments on possible tax reform in the U.S. While there are countless proposals, and frankly, I don't think anybody really knows what's going to happen, we took a shot at providing one pro forma scenario on page six of the CFO commentary document. We took 2016 and computed our pro forma earnings, assuming the U.S. federal corporate tax rate drops to 20% and related AMT is eliminated.
This is just one simple scenario, but it does show that our core adjusted brokerage and risk management EPS could increase 18% and be up 10% in total company adjusted EPS. Additionally, in this scenario, please know that there would be a non-cash write-off of our deferred tax assets of about $25 million, but we like the looks of an 18% and 10% step-up in adjusted EPS. We hope that you find this disclosure helpful as you evaluate potential changes, if any, to the U.S. tax code. Pat, those are my comments. A great quarter, an excellent year, and more importantly, we're really well-positioned coming into 2017. Back to you.
Thank you, Doug. Before we go to questions and answers, I'd like to make just one comment. Marcia Aiken of our investor relations department retired after 36 years with Gallagher. We'll miss Marcia and wish her well in her retirement. I know many of you on this call are familiar with and have worked with Marcia for years. Donna, would you go ahead and open it up for questions, please?
Thank you. The call is now open for questions. If you have a question, please pick up your handset and press star one on your telephone at this time. If you are on speakerphone, please disable that function prior to pressing star one to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing star two. Again, that's star one for questions. Our first question is coming from Kai Pan of Morgan Stanley. Please proceed with your question.
Thank you. Good morning.
Good morning, Kai.
Good morning. We will miss Marcia, too. My first question on the organic growth. Clearly, for the full year, 3.6% is above the original sort of guidance between two and a half and three and a half. If you look beneath it, you look at your supplement and contingents, it's actually growing very fast, like 15%-16% year-over-year. I just wonder what's behind that, and shall we expect it going forward?
In terms of the supplementals and contingents, I think that's indicative of the kind of work we're doing for our clients, frankly. I mean, I think it's indicative of the fact that we're growing nicely with carriers and that that's profitable growth with very good customers. We work very hard to make sure that the carriers compensate us for the work that we're doing, and I think it shows in those numbers. Remember, when we do acquisitions, Kai, we bring in people that don't necessarily have the same arrangements with carriers that we have, and that improves those results once they're part of Gallagher.
To add on to that, it's a good question. I think that we're doing a lot of work on product development, product enhancement, analytics that really develop a better product for the customers, and the carriers are recognizing that. I think that there's something that's important I've said before. It's a little bit of a blurred line at times between a supplemental and a base commission, is that if you look at if we get an enhanced commission in the field, that would be considered base commission. If that comes in over the top directly from the carrier, let's say, to the region or to the corporate offices, that would be referred to as supplemental. It's basically arriving from the same behavior, delivering a better product to the customer and the carriers recognizing that that service has additional value.
I think the contingents and supplementals, Kai, will grow as we continue to do acquisitions, not at the pace they have in the last couple of years.
Okay. Doug, on that, how much the 43 basis points of margin improvements in 2016 you think is coming from the contribution from the contingents?
I think a big piece of that, I think if you look at where we're having nice margin expansion, the U.S., we're not getting a lot of margin expansion from our units there, as those have done a lot of work already to improve margins kind of to the upper range. We are getting margin expansion from our international operations, too, as we integrate the larger deals.
Great. My last question is on the deal side. You have a strong start for 2017, also in the marketplace, you have recently saw some pretty decent-sized deals, including some potential deals. I just wonder, given that the large deal you've done in 2014 is fully integrated, does that change your outlook or appetite for acquisitions going forward?
Well, first of all, Kai, what we're seeing in the pricing environment, for larger transactions that would either be considered a platform transaction or the selling out of a roll-up, those multiples are levels we don't like. We would certainly not shy away from a large deal if we thought we could price it and if we thought the culture fit. We're very happy with the deals in our pipeline now, which are very much in line with what you saw in 2016.
There's nothing in our pipeline right now that I'd view as a larger deal.
Correct.
Okay, great. Well, thank you so much for all the answers. Good luck.
Thanks, Kai.
Thank you. Our next question is coming from Elyse Greenspan of Wells Fargo. Please proceed with your question.
Hi, good morning.
Good morning.
I was hoping to spend a little bit more time, just some color on the organic. The pickup that you guys saw in Australia and New Zealand this quarter, really just so that you said that was above 4%. Was there anything there, I guess, that would cause you to think that that might not continue when we think about 2017? Just in your outlook for 2017, I guess, how do you see the organic components, domestic versus internationally? Do you think that they'll both kind of maintain that about 3.5% growth?
I think as you saw in my formal comments, we think 2017 all in will look like 2016. I'm hoping that we can maintain greater than 3% as you roll it all together. Australia and New Zealand just had a terrific year. I think we shared with you that Australia, when we did the large deal in 2014, had a base commission and fee that was actually declining. It was declining a small amount but was, in fact, in negative territory. New Zealand has always been in very positive territory. Our team in Australia has done a terrific job over the last two years, and we're now in positive territory in Australia, and New Zealand continues to kill it. I think, again, when you average that back into what's happening domestically, I'm pretty comfortable hoping that we stay in the 3.5% area.
Okay, thank you. In terms of the margin outlook, I know you guys said today what you historically say about 3% or so organic, and you can expand your margins. You're pointing to about 3.5% organic or so for 2017. I know you guys have spoken upon about your efforts to improve some of your international margins, kind of just away from the organic as you integrate some of those larger deals. As we think about the potential for margin expansion, can we think about it coming from, A, just exceeding the 3% organic level and then, B, some of the improvements to the international operations, and how do you just kind of see that all coming together in 2017?
Right. Good question. I think for the margin expansion, it's going to be both. I think organic over 3% will contribute some. I think as we do some of our improvement efforts, we've talked about improving efforts in Australia. There's a little bit in Canada and then in our U.K. retail space. If you look at those businesses, they're all still in the lower to mid 20s when it comes to margins. We have maybe three, four points on each of those businesses. Australia, remember, is a $100 million business. Canada's a $100 million business, and our U.K. retail space is a $350 million business. If you add three points on that on maybe $500 million of revenue, there might be $15 million more of margin lift opportunities there.
If you have organic over 3%, you might be able to harvest maybe 40% of that, 35% of that, of the incremental amount. That's really the nature of the margin expansion that we're seeing here. Again, we've got some nice continuous improvement efforts that we're doing that might bear some fruit in 2018. That's the dimension of margin expansion that we're seeing in this environment right now.
Great. Just one last question. You did point to the pickup in deal activity in the first quarter, and multiples kind of seem about in line with what you saw in 2016. Are you seeing, I guess, some sellers potentially either looking for higher multiples or waiting, just given the uncertainty around the U.S. corporate tax reform?
There's two things. There's an interesting dynamic there. I think that the sellers that really are interested in staying in the business want to do the right thing for their employees, continue to work hard and sell insurance, and really recognize our capabilities. They're really looking at, they're willing to sell for fair multiples. What I mean by fair is somewhere between seven and nine times. It's just that when you're looking for someone that's really interested in taking the money and running, there's multiples out there that can get a lot higher than that. What we're doing is we're looking for folks that have good agencies, good brokerages. They know how to make money already. They've got nice margins. They're interested in staying in the business, and they understand, and Pat uses this all the time, that one plus one can equal three, four, and five.
That's the folks we're looking for. There is pressure on pushing multiples up out there. If we're trying to do 60 deals, nice tuck-in deals a year, there's 60 folks out there that are better together than when they are independent. That's the folks we're looking for, and the pipeline is full of them.
I think Doug hit on it. The pipeline, it never ceases to amaze me just how incredible this business is. One source estimates there's 30,000 agents and brokers in America. If you think about that, in business insurances, number 100 last year did $25 million in revenue. Somehow there's possibly 29,900 firms that are smaller than $25 million, and most of these firms have baby boomers at the helm.
There is no shortage of opportunities for us to find great people. I call every one of these merger partners, and I'll tell you, they're all excited to come aboard because I call it the candy store. Once we let them in the candy store, they know they got a lot more to sell.
Great. Thank you very much.
Thank you. Our next question is coming from Joshua Shanker of Deutsche Bank. Please proceed with your question.
Good morning, Doug, Pat, Ray. I'm really sad that Marcy's not on the call.
She's listening. I know she's listening.
All right. Well, you know.
Give her a shout-out. She'll love it.
We love her. Three questions, they're all kind of interrelated. One, how does strong dollar affect your ability to make acquisitions in the newer regions that you're in? Is that a positive? Do people want dollars or Gallagher shares? Two, I noticed the acquisitions so far done in 2017 appear to be done for cash, not stock, with you going back and buying back the stock later. Wondering if the appetites are changing. Three, there's a lot of news out there about USI coming up for sale. Just wondering how USI's appetite differs from the type of stuff that you write and whether or not USI in the hands of a different owner is a different threat to the Gallagher model.
All right, let me talk about the strong dollar. Well, let me hit cash versus stock. You're right, we do.
You take one and two, I'll take three.
Yeah, that's right. That's great. Cash and stock, we didn't use any net stock in deals in 2016, we don't expect to do that in 2017. That would allow us to do about $750 million of acquisitions in 2017 without using shares. Now, if a person wants shares because for tax planning or they want shares, we'll give them the shares, then we'll buy it back in the marketplace, and we have an 8 million share authorization buyback that's on the shelf. We have plenty of room in that. How do we feel about strong dollars? One of the things to realize is that
Wait, can I answer one question on that, Doug?
Sure.
I thought the point was that if you use the stock, it's a like-for-like transaction that doesn't result in a tax charge. Why would a seller prefer cash to stock if they basically cannot roll over the tax loss, I guess? Or the tax gain.
There are some structures that just are not positioned in order to take that stock. They really don't have that tax planning strategy in that. You'd have to look at the nature of the seller's tax position to understand that more than our willing. We'll give anybody stock as long as we can buy it back in the marketplace.
Those people that want stock, that is an indication of a real partner. We're happy to do that.
Yeah.
If we can arrange it with them to be a tax-free transaction, God bless them. Most of these people come to us with advisors that are telling them, "When you get the stock, sell a good chunk of it anyway." They're happy to take cash.
Yeah. Most of the international folks, really, they prefer cash just the way they're structured and just also owning a in some jurisdictions, they just don't want to own a U.S.-listed company. As for the strong dollar, yes, it does mean that we can buy international franchises at a discount, so to speak, just because of the strong dollar. That's not fueling our appetite for deals. We're not going to rush out to go do a bad deal just because the dollar is stronger. The other thing that's great about our capital management is as we generate cash internationally, we don't have to bring it home. We have reinvestment opportunities internationally. If we're generating GBP or AUD, we have reinvestment opportunities there. It might be opportunities to repatriate it cheaper in the future with tax reform.
Also if we do bring it back to the U.S. and we have to pay an elevated tax, we can use some of our $480 million balance sheet of tax credits to shelter that income from taxation in the U.S. I think that we're well-positioned. We have the opportunity to use dollars around the world. That's easy to move over there. We can use local currency if we want. If the seller wants stock, we're happy to give that because we can buy it back in the market. We have a lot of levers that we can pull in our M&A strategy that allow us to capitalize on the environment right now. As for USI, I'll let Pat talk about that.
Yeah. USI is a solid franchise. Great history. As for them becoming a greater threat, remember, Josh, we have about 32 areas that we have vertical strength. We call them our niches. In those niches, whether it be construction, religious and not-for-profit, higher education, et cetera. I could run down all 30 of them. We believe in every single one of those, we're stronger than anybody in the marketplace, and we don't fear anyone.
In terms of are they similar in Brown & Brown, we've always argued, really goes after smaller business than you. Is USI in your wheelhouse in the United States?
USI is in our wheelhouse in some cities. They're a little bit more disparate group than we are. I think we're a little bit more focused on our niches and working together across profit centers and across the globe in those niches. No, they're good competition.
Also remember, I think that we know that of the publicly traded brokers, we're probably competing against the bigger ones less than 5% of the time when we're out there proposing. It's these other 29,000 brokers out there that we're competing with day in and day out. USI in one city might be strong against us, but in another city, it might be Willis, or it might be the XYZ agency in another city. This is a local business.
I don't worry about any one particular, we don't have a systemic competition against one person anywhere or one broker anywhere.
Yeah, Doug is right. We know that over 90% of the time when we compete, we're competing with the local smaller agent.
Excellent. Well, thank you very much. I appreciate all the detail.
Thanks, Josh.
Thanks, Josh.
Thank you. Our next question is coming from Quentin McMillan of KBW. Please proceed with your question.
Thanks very much, guys. If I could just ask a couple of the Trump-related questions. I assume the organic growth outlook for 2017 is not predicated on any of the policies which may affect you, probably either positively or negatively. One of the things you talked about was infrastructure spending, and if we talk about the niches that you guys have, construction is a very strong one. Can you give us a sense of what size that business is within your overall brokerage and potentially what effect it could have if some of this infrastructure spending does take place?
Well, first of all, yes. Construction is probably our single largest niche in the U.S. In 2016, that niche crushed it. I won't give you the actual organic, but it was way better than what you're seeing with the rest of the company. Anything the new president does in regards to infrastructure spending will fall into the construction area and will be incredibly beneficial to us. Anything that the new administration does relative to healthcare and the ACA, clients will really, really need our support and our consulting capabilities. When I look at what could be coming out of Washington in the next few years, I think it's incredibly positive for us.
Your outlook for 2017 does not include any of that positivity. It's just what you're seeing today, correct?
Correct.
Okay. Just to follow up on the Trump stuff is, there is a thought that the interest income deductibility could go away, and a two-part question for that. One, you guys have some leverage on the balance sheet. What could that mean in terms of an EPS hit? Secondly, in the M&A arena, PE funds obviously use a ton of leverage to do these deals. It could have a pretty negative impact in terms of their business model. What do you see the impact of that playing out in terms of the multiples in the space and the competition for M&A longer term?
I think the competition would become less fierce when it comes to using leverage to borrow and buy brokers. I think that would be helpful for us. What's the impact of a lost interest deduction to us? Basically, you can compute that if you go to page six of the CFO commentary, is that we're getting an income tax benefit of $45 million right now. If that went away, we would just use more of our tax credits. The cash taxes paid wouldn't change that much for us. It wouldn't cause a big negative. It might have a GAAP impact, but we'd use that warehouse of credits that we have on the balance sheet to pay those taxes. Or some of those taxes.
Doug hit on the PE model, Quentin. You're absolutely right. That model absolutely needs the interest deduction to work. The PE firms have driven multiples up. I lived through this once before in my career, that was when the banks decided that the brokerage business was flavor of the month. Every time we'd compete, a bank would be three to five multiple points higher than us. They drove prices up. We basically did fewer deals. When the banks got their belly ache going and decided it wasn't flavor of the month anymore, multiples came down and we did great.
Perfect. If I could sneak one more in just about ChemMod, the midpoint of the guidance as Doug or Pat, I forgot who mentioned, it's about 10% up for next year versus 10%-15% this year. Just wondering, now that mostly all the plants are online, should we continue to expect sort of a similar type growth rate, or is the business sort of in steady state at this point, and we're not likely to see earnings growing much past this into 2018 and beyond?
Good question. We do have a couple plants that we could put in place in 2017 that could start generating in 2018 that could cause a step up. You'd also have to look at utilization of coal for 2018 and beyond would influence that. If the Trump policies to favor coal are successful, you could have coal plants actually producing more. That would cause a step up again in 2018, but it would be modest. New plants could cause a step up. If it's a small plant wouldn't have a big impact, but a large plant, it could have another step up. Wouldn't expect much more after the step up here in 2017.
Okay, great. Thank you so much, guys.
Thanks, Quentin.
Thank you. Our next question is coming from Adam Klauber of William Blair. Please proceed with your question.
Morning, guys.
Morning, Adam.
A couple different questions. Number one on exposures. Are exposures running better, say, now in the last six months than the first six months of the year? Any thoughts on exposures coming into 2017?
Exposures are up a little bit stronger in the second half than they were in the first half. By that, I'm talking basis points. I'm not talking percentage points. I think that 2017 will see a continuation of that.
Okay.
I had a customer in just last night. I spent a good bit of time with a customer yesterday afternoon. He's a mid-size manufacturer locally here. Very locally. I can look out the window and see his plant. He had 22% growth last year, organic. That's stronger than our base customer, but that was pretty positive.
Right. No, that's good news. Similar question on the wholesale submissions. How are they running today versus a year ago?
Stronger, I think as we have expanded RPS. As you know, RPS is the largest MGA in the country, plus it's one of the largest open market brokers and one of the largest program managers. Program side was a little slower, open market broking and MGA stuff was very strong.
Is that in part driven by the construction? Is that the economy doing better? I guess, what's driving that?
Well, I wouldn't say it's in any one specific area. A place where we've gotten more activity but had a little bit more difficulties, of course, transportation. It hasn't been just focused on construction. It's really been across the board. Probably, Adam, driving as much of that is new business startups.
Okay. That's helpful. On the deal front, there was a company, Alera, I'm sure you saw it, snapped up 25 brokers at once. Does that put a dent in the near term supply?
No. Not even close.
Okay. Finally, on the clean energy, when do the benefits from that actually stop? Is that 2021? What happens to that business when it does stop?
Right. Those defined benefits, the cash flows that are generated today should go well into the mid-2020s. The ability to generate credits for our 2009 era plans, they'll be done generating credits at the end of 2019, which is about a third of the production. Our 2011 plants would run to the end of 2011. Again, we're producing excess credits today that would provide a glide path well into the mid-2020s at current rates, and perhaps even longer if we get a tax rate drop to about 20%, our credits might go a little bit longer than that.
Okay, after that-
Also, let me interrupt just a second, Adam. I think also this is a law that applies to solar, to wind, to other clean energy type of tax credits, and maybe there's movement afoot that could extend those, too, in some way, shape, or form past 2021. You'll see a step back in GAAP earnings, but cash earnings will actually exceed GAAP earnings when you get out to that point.
Okay. That's helpful. Thank you very much.
Thanks, Adam.
Once again, ladies and gentlemen, that is star one to register any questions at this time. Our next question is coming from Mark Hughes of SunTrust Robinson Humphrey. Please proceed with your question.
Yeah, thank you. Good morning.
Morning, Mark. I would also like to give my best to Marcia.
Would I.
I know she'll appreciate it.
In the risk management business, could you talk about the claims frequency, particularly in the workers' comp area?
Claims frequency is growing, but along about 1%.
Pat, a little bit of a difference between the indemnity and medical only claims, but the indemnity's up about 1.5% with the existing client base. Not new growth, but thinking of it as these kind of same store sales. Indemnity's a little bit higher than that, but when you bring in the medical only claims, it's right around 1% overall.
How does that trend look compared to, say, three or six months ago?
Three to six months ago, it's probably about the same. If you remember, Mark, if you go back two years ago, it's probably down a point to a point and a half.
Gotcha. Then in the wholesale business, why is the program under a little bit of pressure? Is that competition that's slowing that down?
Yeah, soft market. We lost one program underwriter.
Thank you very much.
Thanks, Mark.
Bye, Mark.
Thank you. Our next question is coming from Charles Sebaski of BMO Capital Markets. Please proceed with your question.
Good morning.
Morning.
Follow-up on that program. Can you tell us what the size is currently of the program business and whether or not there's been any change on the underwriter side on appetites for you guys or any expected turnover there?
Go ahead.
I think the program business is about $75 million in total revenues. When you break down to the area, we're talking about a $40 million business of the piece that we're really talking about here. Certainly what happened is we got the transportation program that we moved to a different underwriter, and that slowed us down a little bit here in 2016. We've got the programs back in place. We've got it working, and we think that could have some nice uplift in transportation in 2017 if the economy starts humming. You got to move all goods and services with the transportation, so that could be better than that. It's a $40 million business for us.
In that business, Charles, we are the underwriter, right?
Yeah.
Soft markets in very specific programs hurt us.
Okay. You mentioned earlier about the performance bonuses internationally, I think you said you thought that they were going to pick up in 2017 after some changeover of a state program. What were the level of performance bonuses in 2016? Kind of when you think of pickup, what a general guidepost would be for that would be helpful.
You can go into the risk management segment, historical financial information. You can take a look at the performance revenues in the past. Basically, they've been running $10 million-$15 million a year. We think there could be a rebound in that. I think this year, the total year to date number is. Go to that. Catch it here for you. Gotcha. It looks like the performance bonuses were down from $15.6 million in 2015 down to $3.6 million this year, there's a possibility of a $10 million recovery on that over time. I don't think we'll pick it all up next year, I think over the next couple of years, we'll do that.
One of the reasons why it's down, I think it's important to understand, is those performance bonuses that we lost this year were predicated on a contract that was written five years ago. As the client stepped up their expectation of our service over the last five years, we hit it four out of the five years. It's just the stretch goal for the fifth year was larger. Our quality actually improved, and our service actually improved, but we didn't hit the stretch milestone that was set five years ago. That's been recalibrated. I think that as we look out, we've renewed that program. We've got a three or four-year contract with them, probably closer to a four-year contract with them, and the milestones, as we look out into the fourth year, we believe are much more reasonable.
I think that the client would also agree that they probably held us to a standard that was pretty high. This shouldn't be interpreted that we missed something. The fact is, the milestones were just a little too high as we guessed five years ago when we negotiated that contract. I think the next one, over the next four years, we should be able to hit it all.
That's essentially all margin, right? It might only be $10 million bucks or something, but it almost all falls to the bottom line, correct?
Right. It does. There's management bonuses associated with it that go in, and staff bonuses that we pay out of it as we hit those milestones. Yes, you're right.
All right. Just finally, thinking about the deal side, I know you give guidance on EBITDA multiples. Just curious, if there is tax reform, does tax reform change your view of the multiples you'd be willing to spend, given you consider on a pre-tax basis, does a lower overall corporate, moving to 35%-20% change your appetite or multiples on transactions going forward?
Yeah, I think the math would say that if you move from 35%-20% on a tax rate, cash flow, just counting on that, you'd probably have to pay a 1.5 times greater multiple on that. I think you'd also look at the spread to our multiple. It'll still be about the same. We're buying at probably a three-point spread to our multiple. Theoretically, our multiple would move up, too. Yeah, it's 1.5 times the multiple. Incremental, so if you're paying seven, you might have to pay eight and a half for the exact same cash. In theory.
Yep.
Just based on the math.
Excellent. Thanks a lot for the answers, guys. Good quarter.
Thanks.
Thank you. Our next question is coming from Sarah DeWitt of J.P. Morgan. Please proceed with your question.
Hi, good morning.
Morning.
Just following up on the potential loss for the interest rate deduction. What would the GAAP, in fact, be? Would that be the $45 million? If that occurred, would you use cash for debt reduction over M&A?
You're looking at it right on page six of the CFO commentary. The $45 million would be a GAAP reduction. Again, we would use tax credits, so there would be no difference on cash, because we'd use our tax credits faster. Would we favor debt reduction over M&A? No. I think that we would still continue to be an active acquirer of nice tuck-in acquisitions, which would pay better than repaying the debt.
Okay.
Remember, when a seller sells, Sarah, they're gone. You can't get someone that wants to sell their business to decide they're going to wait a year and a half.
Right. Okay. Then, on the brokerage margin, nearly 27% this year. I think it's near an all-time high. Is there a natural ceiling on the margin over time, or is the way to think about it as long as you grow more than 3% organically, there's really no limit to that?
Yes, it is an all-time high. I think our margin improvement over the last five years, we're probably up 400 basis points in margins in the last five years. Yes, it is. Trees don't grow to the moon. I think there is a spot where you can have an unhealthy margin. You can't reinvest into the business. What I'd like to think more about is to the extent that we have additional margin expansion, what do we do in order to continue to attract good producers and provide better clients to our customers? We talked about the opportunities internationally. In the U.S., we need to continue to provide the level of service to our customers. There is a terminal velocity that you reach on this.
Okay, great. Thank you.
Thanks, Sarah.
Thank you. Our next question is coming from Ken Billingsley of Compass Point. Please proceed with your questions.
Hi. Good morning. I'd also like to offer my well wishes to Marcia in her future endeavors.
All right. For the rest of you on the call, that's enough.
She's in Florida right now listening to this. Let's not feel too sorry for her.
There you go.
My questions kind of hop around a little bit here. The first one is on the brokerage segment, the $18.5 million line item for investment gains and gains on sales of books of business. I see that on page 13, that gain on sales were negative $1.9 million. Could you just explain what the $20 million investments are, or just what to look at that from a modeling perspective going forward?
All right. There's two things that I think that you're looking at. If you're talking about in the P&L, investment income and gains on realized books of business, there's two pieces in there. Premium funding income that we get on our premium funding operations around the world is in there, as well as book gains. Probably the best place to get book gains would be as we adjust EBITDA. I'm trying to get to that page here. The book gains for the year. Standby, page three.
Page three.
Book gains for the year would be somewhere around, I don't know, $6 million for the year, something like that. Your question, sorry, now I'm anchored on where you are. What was your question? This would be something if we decide a book of business doesn't fit with us, we'd sell it off to a producer. If we want to exit a producer, sometimes we'll sell them a piece of the business that they manage.
Okay, this isn't related to page 13, where you have a gain on book sales for the quarter of -$1.9 of the press release.
All right. Page 13, 14 on the press release. I'm still trying to get to where you are. $1.9 there. Well, what we're doing is we had a gain of $1.9 million on a book, when we get to adjusted, we take reported, and we're reducing that gain as we get down to adjusted, because we just sold off a small piece of business.
The premium funding would be the remaining around about $16 million of premium funding for the quarter?
No, not in investment income. You look at investment income, the $16.6 million, you take out the book gain of $1.9 and you'd be somewhere around $14. Maybe I misheard you.
All right. I'll follow up after the call.
Yes, the rest of it would be premium funding income. The extent that you pull out in book gains, the rest of it would be premium funding interest income, and then you'll have an interest expense down in the P&L also.
Got you. Moving on to coal. I would imagine you made some comments earlier that under Trump, it would appear positive for usage and such. On the tax side, do the plant owners own a piece of the tax benefit, or does someone else own that? The question really just relates to what's the incentive and desire if regulations are reduced in general for them to use the clean coal as opposed to not using the plant in their process?
Right. First of all, we own the plant or the facility that actually creates the clean coal. Gallagher, plus our partners, own that plant. We take possession of the coal, we treat it, and then we sell that coal back to the utility. As a result of that, the utility can meet their environmental needs that they want to meet. The utility does not participate in the tax credit. They get a processed, refined coal that's clean, and that's their incentive to use the clean coal plant.
If there's any change in regulations on that side, do you guys have contracts, future contracts of purchase obligations with you guys?
If there's a change in environmental regulation, yeah, it could have some impact on their desire to make a clean coal. Most of our utility plants, it doesn't cost them anything to use this clean coal to a great extent. I think they continue to use it. We really haven't had any mercury standards for the last 10 years, and they've been using clean coal since then. I think that they would, for the better good of society, I think they'd continue to use it.
Your answer there, does it cost them more to use yours, or you said it doesn't cost them any more to use yours?
No. Does not cost them more to use it.
No cost. Okay. The last question was, I just want to kind of talk about healthcare, ACA, your employee benefits segment, and more of the discussions you may have had initially with some of your smaller accounts. Don't know where it's going to go, but if some of the smaller accounts that didn't have to offer healthcare benefits, and there's some changes and they no longer have to, in your initial conversations, given where unemployment is, what's their thoughts about retaining and hiring people? Is it something that they're likely going to continue to offer? I'm just curious if you've had any initial conversations.
Yeah, initial conversations, Ken, ACA's not that old. You go back in time, the number one challenge for most business people is getting the right team together, right? It's getting the right people on the bus. If you're going to do that, for the most part, you got to have attractive benefit offers. Now, there were very small accounts, obviously, before ACA, that were not offering benefits to their people. By and large, the majority of the clients that we talked to would continue on doing exactly what they did before the ACA, which is making sure they had a benefits package that was attractive to their employees. What they want is help understanding where this thing is going.
If anything, maybe a reduction of what maybe is in the healthcare from the change in ACA, but definitely not going backwards and removing it?
I don't think there'll be a reduction. I'm not going to give you any numbers or %, but when there's change in the marketplace, it's good for Gallagher.
Yeah. One of the things to also remember that in our practice, our employee benefit consulting and practice, is that we don't do a lot of customers that are under 50 lives. It's just really not. We tend to be, when they start getting over 100 or towards 500 to 5,000, that's where we're playing. The number of small customers that really are kind of getting whipsawed by all this, that's really not where we spend most of our time and effort. It wasn't a big practice before. It's not a big practice now. We do it really well for a small customer that wants to use our services. By and large, we don't play in that space.
Very good. Thank you for taking my question.
Thanks, Ken.
Thank you. Our next question is coming from Mark Hughes of SunTrust Robinson Humphrey. Please proceed with your question.
Yeah, just quickly on interest rates. Doug, where do we have to get this in terms of rates at the short end before it starts having an impact on your investment income? Alternatively, what's the risk that higher interest rates tempt carriers to be more aggressive on pricing?
Let me take the carrier and work backwards on this a second. I think the carrier side, they're still having portfolios that are rolling off at higher interest rates, and so their net renewals, as their portfolios roll, it's going to be renewing down. New money coming in to the extent they would grow would be slightly higher than last year. We're up 75 basis points. On the short end of the curve, probably going to take another 50 basis points in order for it to take any meaningful difference on our results, but it will drop into investment income at that point. You remember the days when we were getting 6% on our short money. That was pretty good, huh? I think that was about $20 million back then. Now it would probably be closer to $100 million.
Yep, very good. Thank you.
Thanks, Mark.
Thanks, Mark. Any other questions, Donna?
No, sir. I'd like to turn it back over to you for any closing comments.
Great. I do have a quick closing comment. First of all, thanks again, everyone, for being with us this morning. We do believe 2016 was an excellent year for Gallagher, and our focus remains on executing on each component of our value creation strategy. We will grow organically in 2017. We will grow through acquiring the best brokers. We will improve our quality and productivity, and we are going to continue to invest and celebrate our culture. We think 2017 will be another great year as we build on the success of 2016. Thank you for being with us this morning.
Ladies and gentlemen, thank you for your participation. This concludes today's teleconference. You may disconnect your lines at this time.