Good morning. Welcome to Arthur J. Gallagher & Co.'s fourth quarter 2012 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 call, including answers given in response to questions, may constitute forward-looking statements within the meaning 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 described in the company's reports filed with the SEC. Actual results may differ materially from those discussed today. It is now my pleasure to introduce J. Patrick Gallagher Jr., Chairman, President, and CEO of Arthur J. Gallagher & Co.. Mr. Gallagher, you may begin.
Thank you, Christine. Good morning, everyone. Welcome to our fourth quarter and year-end earnings conference call. Today I'm joined by the division heads that run our businesses, as well as Doug Howell, our Chief Financial Officer. Before I get into my prepared remarks, I want to thank the sell side that are listening today. I think many of you have probably seen the December 2012 and January 2013 issue of Institutional Investor. In that magazine, the sell side voted Doug Howell the best CFO in the insurance business. I think that's well deserved. Today, we're going to talk about the quarter and the year-end, another record quarter and a record year. I'll tell you, it feels really, really great. Our team hit on all cylinders throughout all of 2012. Our growth came from all operations across all geographies.
I couldn't be prouder of the team and our results. We're growing the company for our shareholders year in and year out, quarter after quarter. We're getting stronger in our capabilities to deliver services to our clients and to attract new business. In the fourth quarter, we did 21 acquisitions, bringing in $76 million of projected revenue. Our legal teams, our HR teams, all the support groups, seamless efforts to put these people on the books. Incredible, incredible work. The fourth quarter was also a testament to our sales culture and the strategy we've focused on for years. Every day, we focus on four things I've mentioned on this call many times. The first is organic growth. Everyone in this company knows that nothing happens until somebody rings the cash register.
The second thing we're after is mergers and acquisitions and attracting the best entrepreneurial talent in the marketplace to our growing family. Third is productivity and quality. We're always looking to do a better job for our clients and to improve our margins along the way. Fourth, we work hard every day at maintaining our unique team-oriented Gallagher culture. Thinking about these four things every day has served us well. Those are the four things we're going to stay focused on as we go into 2013 and beyond. When you look at our brokerage segment and risk management segments together, adjusted revenue was up 14% in the quarter, 15% for all of 2012. Adjusted EBITAC was up 17% for the quarter and 20% for the full year. Margins expanded in the quarter and for the full year.
All in all, an excellent quarter, another record year for Gallagher. Our production force is winning. They're turned on and really providing great results. The fourth quarter is our eighth quarter in a row that we have posted positive organic growth. Many of the things that succeeded for us in 2012, we believe will carry over into 2013 and continue to prove successful for us again. In 2012, we completed 60 acquisitions, bringing in annualized projected new revenues of $232 million. We project $130 million of that will hit our books in 2013. This is again across all divisions, across all geographies, and our pipeline still remains strong. These firms added greatly to the niche expertise we talk often about and to our geographic footprint.
They brought us a couple of hundred new producers who now are armed with our capabilities and who we expect will produce significant new business in 2013. Think about it. We give the production force greater opportunities to grow their book of business and to make more money. Our risk management segment, Gallagher Bassett, for 2012, had revenue growth of 7%. Adjusted EBITAC was up 11%. Organic growth in base domestic and international fees for the quarter was 2.9%. Importantly, the way we handle our clients is recognized. Gallagher Bassett was recognized by Business Insurance readers as the top TPA for both small and medium-sized companies, and this is the fifth consecutive year we've been recognized by the readers of Business Insurance. Again, the sales culture is strong. New business was excellent throughout 2012. It was especially strong in the fourth quarter.
In addition, we continue to have strong business retention. Our account retention across both segments is nicely in the mid-90s. Our sales teams are doing a fantastic job of explaining the value proposition that Gallagher has to offer through the entire insurance spectrum. Let me move to a number of individual operations, and I'll start with the brokerage segment. In property casualty retail, we continue to see rates increasing. It feels as we start 2013, very similar to what we felt in 2012. Most lines are experiencing mid-single digit increases. Catastrophe exposed property, especially in the Northeast, looks like it's going to be up a little more than that, and workers' compensation could be a bit higher across the country as well. We are not experiencing a traditional hard market, but rates are moving up consistently across all lines.
As I mentioned, workers' comp is a line in many states that's in distress, and we are seeing increases excess of 10% most of the time in that line. Again, this is not a balance sheet driven correction. These are income statement driven corrections. Carriers realize they're getting no investment income and loss costs are continuing to rise. With costs inflating, a flat renewal is actually a step backwards for the carrier. The senior managers at the insurance companies we trade most with remain resolute that their team has got to get them increases. We have not seen the discipline abate during the quarter. By and large, rates are continuing in positive territory. I want to emphasize that I believe steady increases handled over time are much better for our clients than a dramatic change.
Adjusting to low single digit increases after virtually eight years of rate decreases is much more manageable for clients. Nobody wins when rates jump 50%-100% and insurance is difficult to buy. Also remember, you have to recognize that rates are now still at levels we saw in 1999, which was before the last really hard market. As it relates to the economy, I believe the fiscal cliff and lack of clarity around taxes negatively impacted our clients' businesses, especially in the second half of 2012. As we come into 2013 and there's more clarity around what's going to happen in that regard, we believe our clients' businesses are showing a little bit of improvement because we're seeing this in some positive audits.
If we can see a continuation of positive rates and a little improvement in the economy, we believe we've got really good momentum going into 2013. Let me touch on our international brokerage. We had a very strong quarter and a very strong 2012. The acquisition a year ago of Heath Lambert has given us a great platform to bring a whole new opportunity to our merger and acquisition efforts. Our pipeline continues to be strong. We completed seven acquisitions internationally, four in the U.K., one in Australia, one in the Caribbean, and we purchased 21.3% of Grupo OCP in Mexico, which cements what was already an excellent relationship going back well over a decade, with the Casanueva family in Mexico City, and it opens up great new opportunities for us in Central and Latin America. Our wholesale and MGA business had a strong finish to the year.
New business was strong. Our hit ratios improved on submissions. Our submission growth was solid. We saw continued organic growth in the business, which we feel really good about. Business is moving back to the excess and surplus markets, and we have a team of professionals that know these markets inside and out. On the MGA side, according to Business Insurance, we're the largest firm. We saw an improvement in new business startups, which also helped us grow organically. Let me move to our benefits business, and I want to spend a little time here. The benefits business is in a really good position. I think we are positioned to do extremely well on behalf of our clients, in what is a real changing environment.
Our benefits operation did 33 acquisitions in 2012, I think this is another example of our efforts to be prepared for the new healthcare law, those efforts really paying off. These new firms will bring in a projected annualized revenue of $82 million. What this is showing me, again, and I've mentioned this to many of you, I believe that independent benefits brokers need much stronger consulting expertise in order to deal with the changing environment. I expect pressure to continue to build in that regard, because as we get closer to 2014, many of the law's provisions go into effect. During 2012, we also announced the formation of a private exchange in partnership with Liazon. We can now help our clients, whether they prefer to continue with a defined benefit approach or a defined contribution approach.
Still, too many clients are sitting on the sideline thinking that they're just going to maintain what they've got and deal with the law down the road sometime. I had a long conversation with a sizable client just last evening, and I couldn't get him off the dime as it relates to being prepared for 2014. I think that's going to create a tremendous opportunity for us. In the near and long term, we have built the expertise to be able to deal with this changing environment. Go back to our total M&A efforts this past year, 60 acquisitions, $232 million of new projected annualized revenue. Our pipeline is strong and clearly a key part of our growth strategy is to continue to attract strong entrepreneurs into our firm and to give them additional capabilities to grow.
As I do every quarter, I want to stop and just thank those who joined us. I know you had choices, and we're very glad you chose us. Welcome to our expanding family, and I know you'll contribute substantially in 2013 and beyond. Let me move now to our risk management segment. Another solid quarter, another great year. We've now completed our wind down of the New Zealand earthquake activity, and we've ramped up our operation in South Australia. Think about this. In two to three months, we hired 185 people. We got them situated, trained, and ready to pay claims in two to three months. Unbelievable work by the team. Our international operations contributed greatly in 2012, and they'll even do a greater amount of contribution in 2013, especially with the addition of South Australia.
We've invested over the past year in new IT tools that we refer to as the analytical workbench. These continue to be well received by our clients, and we're continuing to invest in client facing products and services, which should keep us in a really strong position both for renewals and for developing new business. Even with ongoing investments in our service offering, we maintained our target margin of 16%. I continue to be very excited about the power the company is building to help our clients in this really risky world. Our culture, as I mentioned before, is strong, and I can't emphasize this enough. We're client focused, team oriented, upbeat and winning. All of us are involved in selling and servicing our clients, and we firmly believe as an enterprise, we're just getting started. Over to you, Doug.
All right. Thanks, Pat, and good morning, everyone. Let's jump in and start on the second page of the earnings release with the brokerage segment. The first item you're used to seeing is the Heath Lambert integration cost. The end is in sight, and we're on track to wrap up the integration in mid-2013. You'll see just a couple of pennies of integration cost in the first and second quarter, and then about $0.03 in the third quarter. The third quarter actually reflects the cost to consolidate most all of our London operations into new space near Lloyd's, which will be the capstone on nearly two years of hard work by the team to put these organizations together. The next item is a $0.05 charge relating to contracting our middle and back office.
We took these actions at a time of strength because it was the proactive step to realize savings from our process improvement initiatives, increased utilization of our operational service centers, and our investments in improving technologies. It's also a prudent step to offset the impact of medical cost inflation, to reduce the financial impact of our frozen pension plan, and most importantly, allow us to continue to recognize and reward the broader workforce. The third item in the brokerage segment is we resolved some tax items in the fourth quarter that cost us $0.02. Recall that we resolved some tax items in the second quarter that generated $0.02 of earnings. While it creates some noise between quarters, for the year, they offset and have no impact on our annual numbers. Moving slightly down to Risk Management.
I've already hit on the severance cost item, the next item is the ramp-up efforts to onboard our new clients in Australia that Pat discussed. As a reminder, that client should generate about $20 million of annual revenues here in 2013. Let's move on to page three. The brokerage segment had a terrific organic growth quarter, up 5.2%. That's excellent work by our production folks, especially given they were also up nearly 5% in the fourth quarter 2011. Looking across our units, each of them posted excellent growth. We saw about 5% organic in our domestic P&C operations, a touch over 5% in our domestic benefits units, and a little over 6% internationally. Strong work across the table. Turning next to the top of page four to the brokerage segment margin table. We're really pleased to continue to post margin expansion here in the fourth quarter.
Looking at it on an annual basis, for margins to be up 70 basis points on 4% organic growth is really, really good work by the team. More importantly, because we took the proactive steps to offset workforce-related benefit and compensation inflation, we are well positioned to control our compensation costs coming into 2013. Next, while we don't normally spend time in these calls on the non-EBITDA items, let me pause for a second and give you some thoughts related to modeling depreciation, amortization, and change in acquisition earn-outs in 2013. For depreciation, assume about $8 million of expense per quarter. For amortization, assume about $27 million of expense per quarter, plus you'll need to make a guess for amortization from new M&A activity that arises in 2013.
Finally, for change in acquisition earn-outs, assume about $3 million of expense per quarter, and that will cover the amortization of the discounted earn-out payables. Also, as my annual reminder, please use our investor supplement that we post on the website to build your models. The adjusted pages remove difficult to compare items, which is helpful when you set your baselines. It also highlights how seasonally small we are in the first quarter, which, like I said last year, has become even more pronounced because Heath Lambert is also seasonally smallest in the first quarter. Move down on page four to the Risk Management organic table. The temporary revenues related to the New Zealand earthquake claims are all but gone, and without those, we posted nearly 3% organic. This is down a bit from previous quarter, and we believe that is an anomaly for two reasons.
First, we eased back a bit on new business in Australia as the team ramped up for the new $20 million account. We did lose a decent account, which unfortunately happens from time to time in a competitive business. We believe that's an anomaly. That said, to post 5.7% organic for the full year is really good work in an economy that isn't seeing much employment growth. As we look towards 2013, we are seeing an organic growth environment similar to what we saw in 2012. Plus, we'll add about $5 million per quarter of revenues from our new Australian client. Moving to the middle of page five to the risk management margins.
Recall last year at this time, the team set out to push its adjusted EBITAC margins up about 50 basis points to 16% and also cover about a full margin point of cost to develop some exciting client-centric tools and resources. You can see that they delivered. It was great work by the team. This investing will continue in 2013. Yet, with productivity gains, we are still targeting 16 points of margin. All right. Let's move to the bottom of page five to the shortcut table for our corporate segment. For the fourth quarter, we posted a loss of $0.05, which was right in line with our $0.04-$0.07 loss that we forecasted in our third quarter call. For the year, we came in at $0.03 versus a loss of $0.26 in 2011. Virtually all of that improvement came from clean energy investment earnings.
As for 2013, rather than rattling through a lot of numbers on this call, we've expanded page 14 of our investment supplement on the website to include our current best guess range for each of these corporate segment line items. The punchline from that schedule is that the corporate segment should post between $0.17 and $0.34 of earnings in 2013 versus $0.03 of loss here in 2012. Page 14 also shows quarterly ranges because there is pronounced seasonality in our clean energy investment earnings, so please use that page when building your quarterly models. As a last thought on clean energy investments, it's important to remember that it was only 13 months ago that the team built and placed into service 15 new plants. Now, when you read page six of the earnings release, you'll see that we are only left with a few uncommitted plants.
When you look at page 14 of the supplement, you'll see that we could make between $75 million and $90 million in 2013 from these investments. If we continue to have success in ramping up the other plants, that could bode well for even better earnings in 2014. The important takeaway on all this is that these investments could generate substantial cash flows, which we will use to continue to fund our M&A program. That leads me to my wrap-up commentary on capital management and funding our M&A growth. In our last earnings call, I said we would not use much stock to do M&A in the fourth quarter. We did not. As we look towards 2013, we intend to again favor cash and more debt to fund our M&A activity and avoid using stock.
We currently have about $160 million of cash in the bank. We are also working on another $200 million of 10-year notes. All that said, if M&A activity exceeds last year, realize from time to time, we must use stock and tax-free exchanges, we might need to use some shares. We are currently favoring cash and debt. Those are my comments. It has been a really exciting year. It is time to put 2012 on the shelf and focus on delivering some excellent results here again in 2013. Okay, back to you, Pat.
Thank you, Doug. Christine, we are ready for questions, hopefully some answers.
Thank you. The call is now open for questions. If you have a question, please pick up your handset and press *1 on your telephone at this time. If you are on a speakerphone, please disable that function prior to pressing *1 to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing *2. Again, that is *1 for questions. Thank you. Our first question is coming from the line of Michael Nannizzi with Goldman Sachs. Please state your question.
Hi. Yeah, I have one question on the charge. Just trying to understand what came first. Was it the expectation that you would have that $35 million expense, was it the expectation that you would incur these workforce savings? Just trying to understand the thought process around the determination of that number. Thanks.
Good question. Just to clarify, we took $12 million of severance and related costs of charges. We expect to save about $35 million, of which much of that will be offset by what we refer to as just workforce inflation. Those were planned reductions based on our work in August and September to look at our staffing levels in light of the ramp-up of our offshore centers of excellence at looking at our technologies and looking at our productivity gains. It was a necessary step in order to harvest the savings that we expect as a result of the investments and just getting better at what we do every day.
Got it. If we were to peel that out, just peel that piece out for a second. The second part, which is the increased medical costs, reduced discount rate on the pension plan, salary increases, performance-based compensation, long-term incentive. Is that new, or was that the result of the study, or was that something that you expected that you would be incurring anyway down the road?
Those costs are always in play. Medical cost is going up. I think the decline in pension yields has been there, and we've known about that. Giving raises and incentive comp to our broader workforce is something that is in our numbers every year. This is something we saw it. There was no surprise there at all.
Got it. Great. Thank you.
Thanks, Mike.
Our next question is coming from the line of Arash Soleimani with Stifel Nicolaus. Please proceed with your question.
Hi. Good morning. Just a couple questions.
Good morning, Arash.
Good morning. I just wanted to clarify on Doug's comment on the M&A financing. Would it be fair to assume that it would be roughly 75% cash and debt and then, I guess 25% stock? Is that kind of a fair breakdown?
No. We intend to use 100% cash and debt to fund our M&A program, unless for some reason in the structure of a deal we need to use stock in order for it to be a tax-free exchange. If we have a merger partner that has a strong desire to hold stock, we would consider giving them stock in that transaction.
Right.
By and large, we're going to favor cash and debt.
That should continue into 2014 also, that logic?
Yes, it should. Again, if our acquisition appetite grows, we would have to use stock in the deal. We're trying to keep our debt somewhere south of two times debt to EBITDA. At some point, if we really have a strong M&A pipeline, we'd be back to using stock towards the end of the year.
Okay, great. Then my other question, in terms of monetizing ChemMod, is there any update in terms of the timing of that.
We had talked about that last year, of trying to be ready by the end of 2012 on that. We think it's more of a mid-2013 exercise at this point.
2013. Then lastly, in terms of the health exchanges, I know you have the partnership with Liaison. Are you guys also looking to form other partnerships with other exchange platforms, or do you think that's going to be the primary partner for the next 24 months?
We're entertaining partnerships with other providers as well.
Okay. All right. Great. Thank you so much.
Thanks.
Our next question is coming from the line of Gregory Locraft with Morgan Stanley. Please state your question.
Hi. Good morning.
Good morning, Greg.
Just wanted to pursue, I guess the core operations look great. Just on the coal side, a very helpful chart in the supplement where you give forward guidance. Can you just go backwards, though, and talk a bit about what the guidance was versus what the actual came in at for Clean Energy, and why the differences?
Yeah. Fourth quarter guidance, we guided $0.04-$0.07 of loss for the Corporate segment. The Clean Energy production in the fourth quarter wasn't quite as high as I had probably guided, generally due to warmer weather in a couple of the locations where we have plants. In compared to the fourth quarter, we're a little short on that, but still not too bad.
Okay, what you really want us, Doug, to do is to focus on the Corporate segment guidance all in, not on the component parts as much. Because obviously, we keep cutting finally the numbers, and there's going to be puts and takes. What I'm trying to understand is just $0.75-$0.91 on Clean Energy, how baked in the cake is that? What's the difference between $0.75? What's the difference between $0.91? That kind of thing.
I understand your question. We're highly dependent on the activities of the utility to dictate how much they actually burn of refined fuel or clean coal. We sit down and we go through with each of our utility partners, and we get their best guess with respect to production for the next year. We do suffer from weather issues, from plant maintenance issues. I would say that our $70 million-$90 million is our best guess at this point, based on what we know now. I think it's a range that we feel reasonably comfortable with.
Okay, any of these contracts that you talk about in the release that could come through mid-year, is that all upside?
We have taken our best guess with respect to ramp-up of all of the plants that we disclose in page six, it does not include any of our best guess for the plants that have not been put into the construction phase at this point.
Okay. Perfect. Great. Jumping to the M&A side, just an awesome year as you mentioned.
Thank you.
It seems like people are choosing you as the destination. I guess what I'm trying to do is just model it, and I think you've been very upfront in saying, take all free cash flow. Do we then add an additional amount due to the clean energy funding, so say $75 million bucks on top of free cash, and then that becomes effectively the budget for M&A in 2013 and forward?
Yes.
Perfect. Okay. Any incremental debt you'd add? You did mention less than two times, and you could squeeze some in there.
In my comment, I said we're right now looking at adding $200 million.
Okay. I missed that.
We've got $160 million in the balance sheet. We got free cash flows that we'll develop this year, plus $200 million of debt. We have a lot of money to spend on acquisitions this year.
Great. What's the rough revenue range at which you buy these things at? How should we think about backing into what you think you can get in the market?
Our multiples of EBITDA have been between six and eight times, historically.
Okay, perfect.
We don't buy on revenues, we buy on EBITDA.
Yeah, of course. Okay. That's great on that. The last one for me is just the organic is sort of above that 3% threshold where I think you guys have said, at least in the past, I think you get margin expansion above that level. It seems like we should continue to-- we're running at a good clip there and no break in trend. Should we just expect what we've been seeing going forward on the brokerage side?
We feel like the environment this year is a lot like last year at this time. When it comes to margin, I've always said don't expect much margin expansion unless we have organic greater than 3% in the brokerage side and 5% in the risk management. With the proactive steps we've taken to control our compensation and benefit, the natural inflation in that, we feel good about our prospects for holding and expanding margin in 2013.
Okay. Great. Actually, I'll squeeze one last one just for Pat. Just your view on the cycle. You mentioned quite bullish comments on pricing and where it's heading. Do you see an acceleration in the rate of change, or do you think we're more in a unique world where we're in, call it, 5%-10%, depending on the line for the next few years?
I think we're in a unique situation. This is my fourth cycle. It's completely different than anything I've ever seen before. I do think it's in that 5%-8% continual pressure to push rates up.
Okay. Multi-year.
Well, we're going into the third one right now.
Okay, great. Thanks, guys. Nice year.
Thanks, Greg.
Our next question is coming from Sarah DeWitt of Barclays. Please state your question.
Hi. Good morning.
Good morning, Sarah.
I was wondering if you could elaborate on what drove the acceleration in brokerage organic growth versus the third quarter, and maybe if you could break that down between what you're seeing in terms of rate versus exposure versus new to lost business, that'd be really helpful.
I'll give you a general comment and let Doug comment on the breakout if he can. We just had a great fourth quarter in new business and retention. Frankly, coming into the fourth quarter, in December in particular, you know what your pipeline looks like, and you don't know what your orders are going to look like. It's an aggravating quarter and an aggravating month for me, to be perfectly honest, because you can get hurt by one big loss. You can really be helped by various operations doing well. This is just a time, we're in the fourth quarter, and in December in particular, across every geography. Our international operations had an incredible quarter. Our MGAs and wholesalers, strong organic growth. I already commented on our benefits operation, and our straight P&C retail folks knocked it out of the park in the quarter.
It really comes down to incrementally keeping a better rate of retention and adding more new business. In Doug's comments, this is the thing that I'm really proud of, it was a tough quarter to compare. Last year, if you'll recall, in the fourth quarter, we also did 5% organic and didn't see that level of organic growth again for the three next quarters. To have a big quarter last year and then to do it again this year, is just solid work by the team.
Yeah, I think that Pat hit it. Basically, we didn't get a lot of lift this quarter from the economy, and we didn't get a lot of lift from rate. It was just a little better new business and a little less lost business. That's where we're seeing it.
The rate increases that we talk about, by the way, I should comment on this. The rate increases that we're talking about by account. We're working very hard to offset those for our clients. We're seeing about 1% impact on our revenues from rate. Don't be thinking that just because the carriers are getting an 8% rate increase that necessarily our clients are paying that. They'll take higher deductibles, they'll move to self-insurance. If it's really in a situation where they're squeezed economically, they'll reduce coverage, and the overall impact on our numbers is just 1% from rate.
Great. That's helpful. On the risk management business, could you just talk about what you're seeing in terms of claims trends there? Based on your comments, is it right to think about the right run rate for organic growth around the 6% range in that business?
Well, we thought that the lower run rate for organic in the fourth quarter was an anomaly. Frankly, we did have some impact there, negative impact from a bit of a slower economy. Yes, I would think that our more normalized run rate would be something along the lines of 5%-6%.
Okay. Finally, if I could just squeeze one more in. On the Australia business, is that business running around the 16% margin as well, or something different?
No, about 16%.
Great. Thanks for the answers.
Sure. Thanks for being on today.
Our next question is coming from Mark Hughes of SunTrust. Please state your question.
Yeah, thank you. Good morning.
Good morning, Mark.
Pat, did you say how the workers' comp claims are looking within Risk Management?
Did I say how they're looking?
Yeah.
We didn't mention it, but I can tell you, we're not seeing claim count growth because we're not seeing employment growth. What we are seeing is the same thing that the insurance carriers are finding, is that we're seeing medical inflation within the comp line to a point where the medical costs are growing much faster than the indemnity costs.
Right. You had mentioned, I think, the new business startups were looking better. Could you elaborate on that a little bit?
Yeah. Especially in our MGA book business market, that's very sensitive to that. When the economy tanked in 2009 and 2010, for that business to do well, we need bars and taverns and tattoo parlors and people like that to start businesses. When they do, they end up in the excess and surplus market and in the specialty programs. We have over the last really 3 quarters, seen some improvement in business startup, which is helping us in our MGAs.
A final question, just touching on the margin issue again. Doug, other than 5% organic but 40 basis points in margin in brokerage, should we expect a bit more than that if you're able to hold this kind of organic growth, or is that an appropriate number?
No. Listen, I think behind the 40 basis point expansion of margin this quarter, there's a couple of subtleties that I think you should think about. First is margins would've expanded probably another 20 basis points, but our 2012 tranche of M&A partners happened to be seasonally smaller in the fourth quarter. Just like Heath Lambert is smaller in the first quarter, this tranche of acquisitions tends to have smaller margins in the fourth quarter. We also spent about another 25 basis points on more travel this quarter. Half of that was related to the M&A activity, so maybe 12 basis points of expansion.
About 6 basis points were related to our efforts to harvest the productivity improvements that we've talked about that led to our workforce contraction, maybe another 6 basis points related just more to organic travel, to get out there and see our clients and pick up new business. I'm not saying that those are one-timers, but they did have an impact on margin expansion in the quarter that, had we not had the seasonality and maybe just a little less M&A activity, we probably would have expanded another 20 to 40 basis points.
I knew I could count on that level of detail from the award-winning CFO.
There you go, Mark.
Let's just hope.
I'll intrude by asking one. How do those things look when we look at 1Q, the seasonality, the travel, productivity issues, et cetera?
Is the impact similar, kind of slightly diluted in 1Q, or should it be more positive in 1Q?
I think that the organic travel for new business and our existing clients will be there in the first quarter, but as it was only six basis points of cost. I think there's always a natural slowdown in M&A activity in the first quarter. Generally, if you look at M&A activities, when you do 60 deals, the first quarter, people are kind of just catching their breath, and then they target to get stuff done before the end of the year. We always say we do a year's worth of acquisitions in nine months. That should not be there next quarter.
Thank you.
Thanks, Mark.
Thanks, Mark.
Our next question is coming from Adam Klauber of William Blair. Please state your question.
Good morning, everyone.
Morning, Adam.
Good year, good quarter.
Thank you.
Contingents and supplementals were up pretty good in 2012. How much of that is maybe having new carriers come into the program, or how much of that is just normal growth? What do you expect for 2013?
I'll touch on where it's coming from and let Doug touch on what we're sort of forecasting for next year. This is more about having new partners through the merger and acquisition process than it is new carriers coming in. Most of our supplementals and contingents are coming from the same partners that we've worked with in building those programs over the last four or five years. It's building more volume with the carriers that support us, essentially, with those revenues. Yeah. Contributing to that, Adam, is that we've spent a lot of time on carrier analysis and compensation analysis, and that's starting to pay some benefits there. As we look into 2013, frankly, the teams are hard at work, working with the carriers right now to come up with fair supplemental and contingent commission agreements.
I really won't have a big feel on that until the April call. Overall, if you modeled it equal to what we did this year, you wouldn't be too terribly far off. Also, we are starting to see a few carriers start talking about moving back from supplementals into contingents. That would create a timing issue, perhaps, that we'd normally accrue it during the year, but we might get it next March. I'll give you more guidance on that in April on our call.
Okay. In the benefit business, there's been pressure on commissions for smaller businesses, 50 lives and less, even 100 lives and less. Is there any movement by the health insurers to push that up past that 100 to 50 lives?
Adam, for us, that's kind of a non-event, to be honest. We don't do an awful lot of business in the under 100 life case area. What we do is primarily above that level. When you get over 100 lives, even if the client chooses to pay you by commission, it's a disclosed, negotiated, and a discussed fee. It comes through our books as commission, but it's really what the client agrees. We have, for a decade now, made it very clear to clients that in essence, under ERISA for 20+ years, we've been transparent with our clients. If we have a certain level of cost, we need to cover that to do the work for the client. We're very transparent about that. We're very open.
The pressure on insurance companies to reduce commissions is not really impacting our benefits book of business at all.
Can you have some idea, what was organic in the benefits business this year, in 2012?
It was almost the same as what it was for the whole company.
Pretty solid year. Also in that same vein, how is organic in the London operations and Heath?
It's good. I think that I'm actually pretty pleased with the revenue retention there. I think that we are culling out some of that book of business as we look at it to say, if we can't make money, we'll put it out. They're doing a good job of holding in there, and we picked up some nice accounts over there, too. We picked up some very nice risk management accounts with their risk management team and the team that we had in London before the acquisition. We've done an excellent job of holding on to books of business in both the affinity, which is small business programs that we have, as well as middle market in the branches around the U.K. As I said, we've bolted on 4 acquisitions that we never would've been able to do if we hadn't done the deal.
All in all, organic growth is strong there, and M&A growth is strong there, and this team has done a really good job of integrating that business. Just as an example of how difficult that is, you can imagine Heath Lambert's benefits programs were substantially different than Arthur J. Gallagher's benefits programs.
Harmonizing those is really difficult. Our team did a fantastic job of working through that so that we're all now 1 company, 1 set of benefits across the entire platform. That's just 1 example of the work that had to be done.
Great. 1 last question, what was the end of period shares, if you haven't said that?
Let's see. Let me pull it out here. It's $125,600,000.
Okay. Well, thank you very much.
Thanks, Adam.
Thanks, Adam.
Our next question is coming from Brian DeRubio of Yield Capital. Please state your question.
Morning, guys. How are you doing today?
Great, Brian. How are you?
Doing okay.
Good.
Hey, Pat, question for you, or maybe if Scott Hudson's there, maybe he can answer it. If I heard you correctly a few moments ago, you said you didn't see much in terms of claim count growth in Gallagher Bassett. Is that correct?
Organic claim count growth, yes.
They are.
Yes.
How should we think about employment growth, and the ADP numbers were pretty good this morning, how that translates into potential claim count growth? Is there any correlation that we can look to?
It is very correlated. Gallagher Bassett is incredibly sensitive to the economy. When you're working 3 shifts and you take that down to 1 shift, you're going to lose two-thirds of your claim count. Scott, go ahead, comment.
We look at two things. There's the overall claim count growth, which is influenced by the new business we bring on. Then we also break out kind of existing claim count growth. That's the part that we can kind of correlate to the economy specifically. That part of it is, whereas we're talking about 5%-6% claim count growth overall, the part that is influenced by the economic growth is the existing clients is about maybe 1%-2%. It's still relatively low. So until we see an uptick in the economic activity, that part of it won't go much above that.
I'd also comment, Brian, we're not seeing the FTE hires in our benefits book either. Our clients are not hiring people.
Got you.
Their businesses are getting a little better, they're not stepping up and hiring people.
Okay. Next question, it's probably both answerable by Pat, yourself, and Doug. There are signs that inflation's moving up higher. You're seeing it in the yields of 10-year treasuries, most notably. I guess the two-part question, Pat, for you, how do you see that affecting pricing in the business in general? For you, Doug, I know you talked about raising $200 million in debt this year, with your 6.25% notes due in about 18 months from now, would it make more sense for you to lever up a little bit more so you're locking in a lower rate for a longer period of time for when that bond matures in 18 months?
Well, let me take the first half of your question, Brian, Doug can talk about the capital management secondly. What I am really impressed with in this cycle, I think this is both a information situation as well as just strong management. Senior management at the insurance companies know where they're making money. They know by line, by city, by country, by state. They really have information at their fingertips. As I've said before, this is one of the first times in my career where what I'm hearing from the senior executives at insurance companies is actually happening exactly as they're saying it on the street. There's usually a bit of a disconnect as you're getting towards the end of a cycle.
They know exactly what's happening to their cost structure, if costs are inflating, which tort is in fact inflating, medical is in fact inflating, they recognize loss costs are going up they know exactly what % that is what the impact will be on the next year, they are going to try to cover that loss cost with rate increases. It's actually quite impressive. They're doing a very good job. I think our people are getting better and better at explaining that to clients because when it first came about three, four quarters ago, maybe six quarters ago, frankly, all the people we'd hired for eight years, all they'd ever done is sell cheaper insurance with broader terms.
All of a sudden they're explaining to clients that carriers have no return and they're having to become more sophisticated in how they explain how insurance works to clients. It's been quite impressive. I do think that as long as yields remain suppressed, you're going to see carriers that fight hard to try to cover their cost of capital.
Yeah. In terms of debt, Brian, I think that let's get those $200 million put to bed, then we need to look at it a little bit of a longer term. It doesn't pay right now to do that at this point. If we have a little bit of a trough in rates still for the rest of the year, we'd look at doing something with our 2017 tranche.
Okay. Got you. Thank you.
Thanks, Brian.
As a reminder, ladies and gentlemen, if you would like to ask a question, press star one on your telephone keypad at this time. Our next question comes from the line of Bob Glasspiegel of Janney Montgomery Scott. Please state your question.
Good morning, everyone.
Morning, Bob.
Pat, in light of your expense cuts, are you changing the dynamics of the 3% organic being the break-even of margin hurdle?
Bob, great question. Yes, you should look at that. If in the past I've said that it takes 3% to cover the natural inflation that goes on inside of our book, if we believe we've cut that natural inflation by this reduction in force, it would stand to reason that we probably could have margin expansion at less than 3%. You're providing the linkage there.
I've never seen a recovery from restructuring charges so dynamic, 200% plus ROI. How does that phase in?
It's immediate.
It's $35 million. I didn't know whether that was an annual cost or a cumulative cost recovery.
No, that's our one-time severance cost. We expect to harvest $35 million of savings.
$35 million cumulative or $35 million a year?
Year. Per year.
$35 million per year.
Which will offset additional costs, Bob. Don't drop that in the EBITDA.
No, I wasn't. I just wanted to make sure I understood your recovery. That's evenly in the first quarter, your run rate is down by eight and a half million a quarter.
Correct.
You're going to spend some of that on inflation.
Correct.
Correct.
Okay. It sounded like, Pat, for your and my fourth cycle, that we've had together, you're more bullish for this cycle than I've heard you on the environment. Is that a correct read, or?
Yeah, Bob. If I can get mid single-digit increases in rate, if our clients' businesses can recover to even a 2% economic growth, with our new business machine, we will show very solid organic growth, which is what showed up in the fourth quarter. You give me 5%-8% organic growth, I'm not predicting 8% right now, if you see a real change in the economy and rates stay firming, you can show some real growth at the profit line.
Okay. Well, good luck to your 2013, appreciate the call.
Thank you, Bob.
Thanks, Bob.
Our next question is coming from Raymond Iardella with Macquarie. Please state your question.
Thanks, good morning, everyone.
Morning.
Just a couple of numbers questions, because I get a lot of the topics have been covered already. Maybe, Doug, can you talk about the tax rate on the core business? I know we spent some time talking about the clean energy initiatives, it seems like you guys maybe are expecting a lower tax rate going forward.
Yeah, good question, Ray. Yeah, if you read in our press release in the income tax section, we have moved, historically, we'd say 39%-41%, we're kind of south of that now. That has to do with the mix of our international business. As we grow internationally, the tax rates in those jurisdictions are less than what we have here, that does have a tendency to bring down the rate.
Okay. Thank you for that. I know you mentioned the one large client on the risk management side, margins around 16%, but any other sort of drag you guys expect in the first quarter from bringing some of those hires online?
No, I think actually we should hit the ground running with respect to our South Australia clients. I don't expect a drag.
Okay, that's helpful. International versus domestic cash. Do you have that?
Yeah. We have about $40 million free in the U.S. and about $120 million internationally. When I gave the $160 million of free cash, it's about $40 in the U.S. and $120 internationally.
Okay. Then I think I missed the number at the very beginning, Pat, in your prepared remarks where you talked about, $232 million of acquisitions that you guys did in 2012. What was the expectation for 2013 for those acquisitions?
$130 million.
Okay.
The rollover, Ray.
That's the rollover.
Yeah.
Yes. Okay. Thanks a lot. Thanks to you guys.
Thanks, Ray.
Thanks, Ray.
Our next question is coming from the line of Joshua Shanker of Deutsche Bank. Please state your question.
Yeah, thank you very much. Doug, can we talk a little bit about pace of plants coming online throughout 2013, comparing the early part of the year to the late part of the year?
Just say your question again, you beeped out on the first part of the question.
Sorry. Expectations for the pace of plants coming online.
The pace that we have in here is, if you add up the ultimate numbers on page six, you get a number higher than what we have on page 14 of the investor supplement. What that would imply is that the pace is probably a three-month setback. If you think about the pace of these plants coming on, not going through each one of them, but we have two that we think is going to be in mid-2013, and then the ones that we're currently, like we've been selected as a finalist, those would come up in the fourth quarter, if that works. I think the pace on six, rather than going through each one, is our best guess, but we've given ourselves a few months cushion in each of those pieces.
Okay, thank you. Pat, you said a word that I talk about a lot, but I don't hear a lot, self-insurance as a protection for your clients to avoid paying higher rates. To what extent can you see now in forecasting, if we are in this continuous rate environment, that self-insurance becomes a larger part of the pie?
Every single cycle it does, in particular, the workers' compensation line. Workers' compensation is running very high combined loss expense ratios for the industry as a whole. Something on probably north of 115%. That's going to create a natural push from the carriers to increase workers' comp premiums, those will be offset by people who will join pools, bind together to create ways to self-insure. It'll take individual clients that will form captives or group captives, you'll also see just individual clients that are on the cusp, taking more risk themselves, working hard at loss prevention and trying to not pay the premium, but pay the losses themselves. This is our wheelhouse. This is what built our company. We got into this in the '60s, every single cycle, this is what expands for us greatly.
It really benefits Gallagher Bassett as well as the brokerage side. Now, remember, part of that is a little bit self-defeating on the brokerage side, because if we're writing an account with a very high commission that then takes self-insurance and takes a huge retention, our commissions actually come down. The fees on the Gallagher Bassett side are new fees that we didn't have, but those are a little bit lower in terms of margin. Nonetheless, it's the right thing to do for our clients, we're really, really good at it.
All right. Thank you. That was perfect, because I was going to ask you about margins afterwards, you got it. I appreciate all the answers.
Thanks.
Our last question is coming from Brett Huff of Stephens. Please state your question.
Good morning, congrats on a nice quarter again.
Thanks, Brett.
Two questions. Pat, you said all in, you guys end up sort of squeezing the rate down to 1% on brokerage. Should I just do the math and that implies a 4% in terms of unit growth?
Yes.
The second one, you mentioned, Doug, a little bit on this in terms of the acquired revenue seasonality in terms of a little bit lower margin. I don't know if Doug or Pat is best one for this, but more generally, in the just really big push you guys have done on M&A, have those new businesses you've acquired come in at a lower margin? If so, what is your expectation for expanding that margin to get back to a higher level or your average level or whatever? Can you sort of give us a sense of that?
I think as a portfolio of acquisitions, if you look over time, they come in not that dissimilar to us. All right? I wouldn't say that they fuel margin or depress margin. You can get some quarterly anomalies like we talked about here, but by and large, they look a lot like us. That's an important strategy of our M&A strategy. When it comes to most of these deals, we want to buy successful, growing entrepreneurs that know how to run a business to make money for themselves, and because we want them to make money for us together as a combined organization. We try not to ever buy a small deal that's a turnaround. We try not to buy retirements. We want to buy people that want to continue to produce for us, and that they've shown that they can make money for their family.
Because if they don't make money for their family, they're never going to make money for us when they come in. By and large, these are successful entrepreneurs that run margins that are on par with ours.
In some instances, better than ours.
There's nothing about this, the big tranche that you guys acquired this year that's better or worse than that sort of historical view?
No. The tranches I'm talking about, they just were seasonally smaller in the fourth quarter. Full year, they're on par with us.
Okay. That's what I needed. Thanks again.
Sure.
Thanks, Brett.
Christine, is that it for questions?
We have no further questions at this time.
Great. Let me just make a brief wrap-up comment then. Again, thank you, all of you, for being on the call with us this morning. We appreciate it. As you can tell, we're pleased with our 2012 results. We're excited about 2013. We believe we got a solid strategy. We have a team that we believe is second to none, and we look forward to continuing to grow the enterprise in 2013 and beyond. Thank you again for being with us. Thank you, Christine, and that'll end our call today.
Ladies and gentlemen, this does conclude today's teleconference.