We're going to move right along to the next speaker, which is Arthur Gallagher. I'm very happy, as always, to introduce Pat Gallagher, the CEO, and we have Doug Howell, the CFO. I've been doing this 17 years. We've been doing this for 20. I don't think you've, maybe you've missed one.
Nope, never missed.
Never missed. All right. Well, there you have it.
If you keep bringing weather like this.
This is the first time.
This is the second time.
Well, it wasn't as bad as this.
Yes, it was.
All right.
You know, we were invited to a conference in Boca.
Well, thank you for coming here.
Yeah.
We're going to take the question and answer format today with you all. I thought it might be helpful and great if we could start perhaps looking at the brokerage operation and talking about maybe your main strategic objectives around growth and margin, or however you think about it going into 2014.
Sure. Well, first of all, 2013 was a banner year. I think it sets us up well for a good 2014. If you've listened or followed us at all, you know that we're intently focused on four things every day. The first thing we get up and think about every single day is organic growth. Organic growth is comprised first and foremost by not losing clients because it's hard to fill a bucket with a hole in it. It's very directed at new business efforts. We're very focused as a brokerage on about 32 niches. Some of you will say niches that we believe we're tougher than anybody in the market in, and fear no one, and comprises probably 80% of our brokerage business, and we continue to build those niches out.
Organic growth, everybody in our company, with the exception of the professionals, Doug, our lawyers, HR, come from the street. We're proud of that. We are salespeople. We view ourselves as peddlers, and we view ourselves as support for the effort to go get organic growth. The second thing which we're focused on every day is mergers and acquisitions. We're very active in that space. I think any of you that follow us know that. We simply are out every day, and there are dozens of us that are involved in this process, talking to people that own small entrepreneurial shops. This past two years, we've actually had an opportunity to pick up three larger shops.
By and large, our prospect list is made up of privately owned entrepreneurial firms that have built great businesses, and we want those great businesses to join us, and we want the leadership of those businesses to join us. 98% of our due diligence in the merger and acquisition process is around culture, and will these entrepreneurs stay and help us build our company afterwards? The third thing, you hit right on it, is productivity and margin. We want to continue to get better at what we do every day for our clients. We've done that substantially over the last decade. Our errors and omissions claims, as an example, that's our professional liability, are down substantially over the last decade. We're getting better and better.
We've moved work to offsite, offshore locations where we've had a tremendous increase in quality, and we're getting better at what we do every day. You can see that in the margin expansion that we've had over the last 9 or 10 quarters. Lastly, and probably the most important pillar of the four pillars is we get up every day, we understand that the secret sauce is a very unique culture. We are a people business. We preach that. Our management team believes that. If you go to our website, you can pull down The Gallagher Way. That is our set of values. We believe in those values, and we think if we run the business according to those values, we will continue to attract and retain the best people in the business. That's what we get up and think about every day.
if we could dive a little deeper, probably into each one of those. As we look at organic growth, the growth's been pretty good for the past several quarters. Moved up nicely. Where are you gaining that share from?
Every single day when we go out and compete, we know this now, 85% of the time when we are in a competitive situation, we're competing with someone who's smaller than we are. The depth of knowledge in our organization, Doug coined this phrase about a year or so ago, and I think it's a really good one. He said, "It's great. We go out and we spend $100 million on a firm, and we pick up 1,000 people." What we really did, yes, we wanted that revenue and that continuing earnings, but we got 1,000 more brains. This is a people brain business. We connect those people with Salesforce and our Chatter social media within Salesforce, so that you are expanding the brain power of the organization with every transaction we do.
That allows us, I believe, to be in an incredible position to take share from our smaller competitors. 15% of the time, we're fighting with Marsh, Aon, and Willis, and we win some, they win some. The thing that's kind of neat about our business, if we never took another account from our larger competitors for the next 25 years, our growth opportunities are limitless.
Can you talk about the role that the rate environment plays into your top line? How's that factoring in, and how reliant are you on rate increases?
Well, actually, over the last three or four years, really, rate has not contributed to our organic growth much at all, nor has exposure. An increasing rate environment of 3%-5%, something like that by the carriers, really, our team is really good about helping our customers figure out ways that they can mitigate that rate increase by maybe taking a little bit higher deductibles, taking on more exposure at the top. They do a good job of controlling those rate increases. It doesn't really translate to our organic growth to the bottom line. The fact is, we sell 10%-12% new business, and we lose 5%-7% in lost business. That just gives us forward velocity of 4%-5% in organic growth.
That's really what you're seeing is just we're selling more business than we're losing at this point. Rate really doesn't contribute that much to it right now, nor do I think rate would have that much of an impact even if the carriers started cutting prices 3% or 4%. On a $100,000 account that we might sell A premium. The difference between $98,000 in premium and $102,000 of premium next year doesn't make a lot of difference to the customer. You just don't have that kind of sensitivity around it, and that doesn't translate to that big of a difference to us. We're very comfortable in a flat rate environment. We like to see exposures grow. We feel like that we're more exposed favorably to exposures. When a customer is adding more trucks, you've got to insure those trucks.
When you're bidding on more contracts, you've got to provide the bid bonds on that.
The other thing I think that's interesting here is there's a lot of discussion when we come to these conferences as to where are we in the cycle. The cycle, for those that have been around for 40 years, means that there's a period of time where the rates are very soft and prices are being cut, then at one point in time, like after 9/11, bam, the rates get thrown through the roof. They're up 50%-60% for many clients. Coverage is getting dropped. That's a hard part of the cycle.
This is the first time in my career where we're going into the third year of price rationality, where carriers are saying, "No, listen, I'm not willing to go for market share if you're not willing to pay me the 2%-4% that I need to stay ahead of loss cost inflation." When I first came into the business in 1974, benefits was also cyclical. Typically, the cycle was the opposite of PC, but benefits, there would be people who would go for market share, and then they'd have to raise rates. In about 1980, the cycle completely came out of benefits. What happened? A number of things happened. One, there was a lot more transparency into the underlying cost. Two, there was loss cost inflation that no one could play the game of market share because they got crushed.
You had incredible consolidation. What do we have today? There's no investment income. There's incredible transparency. Sarbanes-Oxley does not allow CEOs to play games year to year with what their real results are. The intelligence that these CEOs have, you'll find this humorous. This is the first time in my career when I have a conversation with the CEOs of our insurance PC partners, and the people in my sales meetings agree. I'm going to say that again. It's the first time in my career that when the CEO of an insurance company says we're getting 2-4 on the street, and when we need 7 or 8 on comp, we're getting it, and I go to a sales meeting and they don't go, "Pfft, they're cutting price like crazy." There is something different here.
Doug's point, if rates are flat to down a bit, if rates are flat up a bit, I mean, for Gallagher, just call us Goldilocks.
If we could dovetail from that for a minute and talk about margins in the same vein. How reliant are you upon the rates to work on your margins going forward in the brokerage operation? We've seen some nice improvement there as well.
Yeah, I think that rates don't have a big impact on the ability to expand margin in a modest rate increase or rate decrease environment. We still get that forward velocity by just selling more than we lose. In this environment, though, if you think about it, I've said this many a time that without 3% organic growth, it's hard to expand margin in this current environment. Here's why. If you take our situation, $2.5 billion of revenue, 3% organic growth gives us $75 million more. A third of it goes to the producers into the field management because it's a variable comp structure there, so we share that with them. A third of it goes to the shareholders as we're touching 25 points of margin. That leaves in the middle $20 worth of additional profits that we can now allocate to our workforce.
If we give a 2% raise on $1.5 billion of payroll, that's $30 million. There are productivity and technology initiatives underway that can continue to allow us to offset other inflation in consumables. For instance, we are getting better and better at how we procure rent, office space. We're getting better and better about how we buy our consumables. There's opportunities to offset natural inflation in those categories. The fact is, at 3% organic growth, it's difficult to have enough money to expand margin. You get over 3%, maybe 4% or 5%, there is more money in that same math that allows us to share that with shareholders. We think in a 3% organic environment, flat margins is a win. We think in 4%, maybe a little bit here, 5%, maybe a little bit more. The fact is, I'm talking without acquisitions.
As you know, with the deals that we've done in the past, some of those can be margin accretive a little bit in terms of because they just run higher margins when we bought them. On the other hand, there's some deals that run slightly lower margins than we do but have nice growth prospects or improvement prospects. 3%, don't expect much. Get a little bit over that, maybe you'll get some.
If we could shift to the M&A activity. You mentioned at the end there, you guys have been very active acquirers, particularly in the past couple of years, two very sizable acquisitions. Can you talk about how you look at that, how you look at acquired growth versus organic growth and what we might see going forward given that you've made such chunky acquisitions recently?
Remember, when you look at our acquisition process, people say, have you now moved to a place in time where you want to do much bigger deals? If you look at the top 100 agents and brokers in America, Business Insurance puts out an article every July on that. To be number 100 last year, you did $22 million in revenue. Over $22 million in the U.S., I got 100 of them, right? If I take Marsh, Aon, Willis, Lockton, Wells, you got 90. Yeah, we're interested in those. At some point in time, if they come available, we look. We won't overbid for them. Frankly, we were not the first choice on Bollinger, and the first choice didn't close, we did. We're maintaining our price discipline.
By and large, if you look at our prospect list, it's the folks that have agencies that are less than $20 million, we have a huge appetite for those, as long as we believe that there are folks that we will enjoy working with and that will stay and help us build the business.
What about are you looking at specific areas? Obviously, you've been building out your international platform. As you look at the M&A going forward, are you trying to target that more aggressively, or is it pretty much across the board?
It's across the board. We have been targeting growth internationally at a much stronger level in the last two to three years than we were before, part of that is I've been opportunistic. The U.K. market, in particular, was way overheated, the multiples that these smaller agents were getting for their business was completely out of the ballpark of reasonableness. Once the PE firms rolled them up and found out that maybe they weren't working so well, the multiples came back into a more reasonable position, we took advantage of the opportunity.
Can you talk about the multiples a little bit and what you're paying for deals?
Yeah. If you look at last year, we paid about 7.5, 7.6 times EBITDA. If you just roll up all the deals, the 30-some deals that we did last year, the average payout was 7.5, 7.6. In the U.S., obviously, we don't pay much tax on those deals, so the multiple on a pre or after-tax basis is about the same. We think that's a fair multiple in this environment. The larger deals typically get a little bit higher multiple. The smaller deals, not quite as high. As a portfolio of deals last year, in that 7.5% range in the current growth environment, that's a pretty fair price. Would we pay up for a better franchise in a new geography that might have a platform for us in that geography? Perhaps we'd pay a little bit more.
The nice bolt-on acquisitions, really what we're doing is we're looking for folks that want to come on and sell insurance with us after the fact. The multiple kind of translates to what do we get out of the folks. If we get some really, really good producers out of the deal and a leader of a branch or an agency that wants to join us because of our resource, our capabilities, and everything, generally, they're excited about joining us. They see the opportunity to grow themselves. I think a multiple in the six to seven range is pretty fair for those folks.
You touched on whether we view this as organic or not. I think it's fair to say when you do a Heath, when you do a Giles, when you do a Bollinger, that's not organic. That's a purchased growth play. By and large, of the 31 transactions we did last year, 15 of them are less than $5 million, $6 million. Isn't that really as close to organic hiring as you can get? Now, we take that out of the calculation, we wait a year to put them back in organic. If you really were saying, well, okay, you hired five producers and a leader and 10 support people, isn't that an organic move? I think you could look at it both ways.
Those are the ones that we really are hoping that those folks come in, like their new platform, can sell, and double the business together with us.
Going forward, we shouldn't use your activity the past couple of years as an indicator that you might slow down or take a step back from M&A activity.
No, I don't think so. I think that we're well-positioned cash flow wise. Our low debt levels at this point, the ability to use stock in the deals, I think that we're well positioned to continue looking. There's lots of deals that are coming up right now, good merger partners that have made a decision that it's time to merge up their family agency, to join, to get our resources, and we're prepared to do that. We have 60, 70 people inside of the organization that are experienced at doing M&A deals that may have come to us through a merger in the past. The integration on these smaller deals is very easy to do. It doesn't put strain into the organization or establish a lot of risk for us to pick up a $3 million agency in Dallas, for instance.
Right.
I'm wondering if we could shift gears for a little bit, if you could talk about, give us an update on what's going on with the healthcare situation and the exchanges, what you're seeing there.
Sure. It seems to be everybody's trying to get their hands around these exchanges, and what's the opportunity of these exchanges. Isn't it this new, great revenue stream that Gallagher is going to get in the middle of and get a whole pile of money out of it because it's a new way to do things? We're kind of an outlier in this, and the fact that I'll tell you that the answer to that is no, in our opinion. We're brokers. We're consultants. Our job is to help our clients sort through all the things that face them as they look at their entire pay and benefits package for their people. Exchanges will be one of those things that they look at and have to philosophically decide where they want to go.
We do have a private insurance exchange ourselves in partnership with Liazon, and that will not be damaged, we've been assured, by the fact that they've sold their business. There are other exchanges being formulated, really what this is it just puts a ton more choice and a ton more things that benefits managers need to be apprised of as they get ready to do what's right for their employees. We don't believe that you're going to see a huge additional revenue stream for Gallagher because this is what we're doing for our clients already. What it is doing for us is getting us more new clients because it's complicated. We have 24 people in our compliance department, and 19 or 20 of them are lawyers. When we go up against a smaller competitor in that environment, they don't have that compliance capability.
We've built the calculators that can tell clients, if you move this way, this is what's going to happen to your costs. This is complicated stuff. I spent three hours this week on our own group. We had an anomaly in the fourth quarter where unfortunately, we had a couple of bad losses in our health insurance. A couple of them were premature babies, and we like taking care of them. All of a sudden, what you'd think in a 9,000, 10,000 person group, you'd think you'd kind of have levelized costs, we got a spike. Now I got to sit with my consultants and say, "Do I have a new norm here? What are my projections for 2015?" This is February of 2014. We're working on 2015.
If I do a nine-month trend, a six-month trend, and a three-month trend, the numbers come out differently. If I look at it one way, it looks like 2015 will trend up 9.8% on a cost that's already costing us almost $100 million. My answer to my consultant, who's a partner of ours for the last 30 years, is, "Bad answer. Go away and come back with a better answer, because we're not going up 9.8% in 2015." The complexity. Okay, yes, I've got a 10,000 person case. You get down to 100 life case, these people are going through the same struggles. The idea that the exchange is somehow nirvana because what it does is it gives the employer the right to say, "Now I'm going defined contribution. You just go buy what you want.
I've contributed." That's what the employer should do. You go figure out for yourself how this is all going to work. You're going to drive your employee base nuts. By the way, as you start to read the articles now, guess what? What do the exchanges come with? Many times, significantly higher deductibles. Many times, skinny networks. What's a skinny network? It's not a very robust network. What's the penalty for being out of network? No cover. I'm just telling you, when one of my kids gets sick and needs to go to Mayo, we're going to Mayo. Right. If that means I got to pay an out-of-network price, I'll do that. I'm not paying the full boat. This complexity is really helping our benefits business.
I think it'll happen year-over-year, too. This isn't a once and done decision. Every year, the human resource leader of that organization or the CFO or the president has to make a decision about what they do with their employee health and welfare plan. Just pushing them over there. Imagine you push all your employees into an exchange that had XYZ carrier providing 70% of it. That carrier decided to pull out of the exchange. The employees now are left with a choice of who provides that cover next. Do you put another carrier in there? Do you break it up? Every year, the decision of what's provided on that exchange. Do you stop using the exchange and pull them back into a fully insured plan? Other alternatives there. You put them into a state exchange.
We're going to have to be there to help them with that decision every year. That is not something they can make a decision on their own.
Think about this. I'm in this business, and I probably spent two to two and a half hours a quarter on our entire benefits offer to our employees because let's face it, that's our product, our employees. I don't spend one hour a year on our property casualty. I can't tell you what our workers' compensation deductible is. I just figure our guys got it.
I can.
He can. I mean, that's how complex this stuff is.
Yeah.
If it's not your business, can you imagine if you've got to stop yourself and you're a contractor, a manufacturer, a professional service firm, and twice a year you're going to sit down with someone that goes, "Oh, by the way, are you familiar with the regs? Do you know what the employer mandate is? Well, don't worry about it because they just moved it back another year." It's great for our business. I mean, I got political with our people, and I got a lot of pushback. I was sending out emails saying, "Write to your congressman and senators. This is a bad law for our country." People say, "Shut up. Be the CEO and get out of politics." I said, "That's fine. Good enough." The best thing that ever happened to our business. It kills all the smaller competitors. Great.
You know, I will keep asking, but if anybody has a question Oh, look at that.
Well, we're members of the CIAB, and we let them do that. I don't spend a lot of time personally in Washington, but I think I kept waiting for a hue and cry to come from small business America. 55 people, I'm in this law. What does that mean? I kept expecting folks to go, "Whoa." You do see articles. Chicago Tribune four months ago said sticker shock is all on the deductibles. You're now hearing a lot more people complain about skinny networks, and legislators starting to say, "Hey, you can't kick these hospitals out of your network." Well, there goes the price advantage. I don't have a clue, but I will tell you what our professionals are telling our clients is that major cultural benefit legislation like this doesn't go away.
ERISA, Medicare, the powers that be will keep working it to try to make it better. All that means is that every month it's going to keep changing, and we've got to stay on top of that. We expect that there could be as many, ultimately, as a million regulations to come out of this system. I'll have 50 people in my compliance department, 150 people. We don't know. Yeah.
Could you talk a little bit, maybe expand a little bit more? There was a question on the conference call about your claims management business, and Sedgwick was sold for 13 times EBITDA, and you talked about how this is a great business. Maybe you could expand a little bit about your competitive advantages, who your competitors are in that business, and what the opportunities are for long term, and where you see that business as a percentage of your overall earnings and revenue, say, over a five to 10 year period.
Well, thank you for the question. We continue to be excited by and believe in being in the claims management business on the property casualty side of the coin. If you read anything at the Insurance Information Institute, there's a gentleman there by the name of Robert Hartwig, who's really, really good, posts a lot of his work, free to use it. He believes there's $1.5 trillion of premium globally in the PC space. One of the reasons we like the claim business is because 65% of that turns into a claim every year. Where's the cost in insurance? It's in the claims. We believe that if over time, we believe we've actually garnered this reputation, that we can prove empirically that if we actually handle your claims, your ultimate settlements will be less. We accomplish two things.
We do a better job of returning capital to the investors, frankly, we get people back to work faster. We take care of people that have fallen down and broken their hip at McDonald's, whatever it might be, we're taking care of folks. That's not going to go away. One of the things we announced, and we didn't mention who it was, and we're not going to, but we mentioned that there was an outsourcing arrangement that was provided to Gallagher Bassett as of the first of the year, which will be about a $12 million-$15 million outsourcing arrangement. It comes from a household name in the insurance underwriting space that basically has said, "You do this better than we do." I see tremendous opportunities there to continue.
It shocks some underwriting companies when I sit with them and say, "You need to understand we pay more claims than you do." They go, "What?" Yeah. If you put Gallagher Bassett and all our premium together that that represents, we'd be one of the largest insurance companies in the U.S. Well, the globe, because we're doing a ton of work in the U.K. and Australia. We are spending money to get better and better at data mining in that regard. We're spending money to get better and better at the professional delivery, understanding the difference. You can't have an adjuster that's used to doing car fender benders handling a broken hip on a slip and fall. You got to get that to the right people. The more you do that, the better your outcomes are.
The more you can prove your outcomes are better, the more you're going to see people want to outsource and what have you. We've believed in that business at a time when all of our competitors were in the business 25 years ago. They all got out. They got out because the honest to God truth is people like you folks in this room beat them up about margin because it's a lower margin business. If I ever saw a business that was at the heart of what insurance is all about, it's the claim paying business. John?
Pat, could you talk briefly just about your venture with Grahame Chilton on the reinsurance side?
Sure. Graham's a pretty well-known name in your business, John, I think it's no surprise that we made a foray into the larger treaty reinsurance world about 10 years ago, and we got out. Now, we never got out of reinsurance. We've always done reinsurance of our captives. We've done reinsurance of our programs in the U.K. and elsewhere. What we got out of was trying to go head-to-head against Guy Carpenter and Aon and Benfield at the time. One of the reasons we got out was because there was such a heavy spend that had to be spent on the analytics. Graham's view is that there is actually not as much of a requirement for that heavy analytic piece as is presently sold in the market.
That there is a place where someone who's really, really good at the transaction and knowing where the market is can provide services at a lower cost to carriers that can do their own analytics. We were pleased that we were offered the opportunity, quite frankly. Graham was going to do his thing with Capsicum no matter what, we were offered the opportunity to be his platform and be a 20% investor in a firm that we believe will be self-funding in its first year. We're excited about it.
Can you give us an update on the tax credit situation in the coal facilities? I know there's been some volatility there. Just how you think about 2014.
Yeah. I think first and foremost, there's always going to be volatility in it, unfortunately. It's just the way that that type of investment works. For those of you that are deep understandings of what we're doing, we basically have tax advantage investments that allow us to reduce our tax rate and generate free cash flow for the company that we can turn and use for M&A activities. In the past, we started from a standing start. Three years ago, we did $3 million of earnings on it, or cash flow on it. Last year, we did $33, and this year, in 2013, we posted $63, and we've provided that we could be up 10% or 15% over the top of that again here in 2014, with still opportunities in 2015 and 2016 to grow it.
The simple answer for these is that we reduce mercury emissions from coal-fired plants, as a result of that, there's a tax subsidy that comes along with that. We think it's a cash generation thing. It's non-distractive to our core operations. There's four people that do this work day in and day out. We have 34 plants there that we're rolling out, and we've got 20 of them kind of in positions. We've got another few of them in lower producing locations that we might be able to relocate. We think that maybe by the end of 2014, we'll have most of them up and running. At that point, we'd like to probably pare back our ownership percentages of those into the 30% or 40% range. We'd rather own 30%-40% of 30 plants than 100% of 10 or 12 plants.
It just provides diversification of risk, more smoothness in earnings. Really it's on track, on target to where we're going and is living up to our expectations on this. Yes, it does produce volatility, especially on the quarters. I would try to provide guidance and help on that, I think that the street's doing a pretty good job of picking that up. We hope that it does produce the cash flows that we expect it to, and it is a nice M&A funding. I mean, if we could clip $75 million-$100 million of free cash flow for the next seven or eight years out of this, because there is a sunset in 2021 on that would be a nice funding for M&A for us.
Great. Thank you. Thank you very much. Thanks for coming.
We appreciate being here.
Happy to be here. Thanks.
It's always a great conference, and we appreciate it. Thanks, John.
Thank you.
Thanks, everybody.