Good morning, and welcome to Arthur J. Gallagher & Co.'s second quarter 2011 earnings conference call. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. If you require operator assistance, press star zero on your telephone keypad. As a reminder, 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 security laws. These forward-looking statements are subject to certain risks and uncertainties described in the company's reports filed with the Securities and Exchange Commission. 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, Bob. Good morning, everybody, and welcome to our second quarter conference call. We appreciate you being with us this morning. This morning, I'm joined by Doug Howell, our Chief Financial Officer, as well as the heads of our operating divisions. As is our custom, I'm going to offer my views on the quarter. Doug will make some comments, and we'll get pretty quickly to questions and answers. As I said in the press release, I'm extremely pleased with our second quarter. The results, I think, were terrific. The team, I think, really came through in the quarter. Brokerage adjusted revenues up 16%, EBITDAC in the brokerage side up 13%, 2.1% organic growth. If I added our supplemental commissions to the organic number, it would've been 3.1% in the brokerage segment. Risk management adjusted revenue up 20%, EBITDAC up 19% with 5.9%, almost 6% organic growth.
If you combine our two operating segments, we produced about 3.7% organic growth in the quarter. Everywhere I look around our enterprise, our numbers are improving. Most of our businesses across the globe contributed to the quarter. I'm really proud of the work our team did this quarter. I think that these results show that the strategies we have to grow our company are working. I want to remind the listeners that all of our strategies essentially fall into 4 main categories. First thing we're out after every day is organic growth. Secondly, mergers and acquisitions. Thirdly, we're focused on operational excellence and productivity improvement. Fourthly, we want to maintain what we believe is a very unique corporate culture. Let me touch on each of these categories briefly. Let me talk about the drivers of organic growth this quarter.
Driving these results was about a one- to two-point increase in new business over 2010 and about a one- to two-point improvement in our lost business numbers over 2010. An incredibly competitive market out there, to improve new business and lost business in the face of that competition is really an achievement. Also, I'd comment, our niche focus, I think, continues to pay results that clients want to do business with those who truly understand their business. We've made good progress in the quarter implementing our sales management software, and I hope that this will help us maintain our new business momentum. Rates actually showed some flattening on the PC side in the quarter. Catastrophe-exposed property, that's Florida wind, California earthquake, some of the property in the middle of the country where there were bad tornado losses this quarter, are all showing signs of increases.
Workers' compensation in many of the states are also showing increases. Main Street and middle market accounts still are receiving some reductions, especially when there's competition. But in many instances, we're finding markets are not willing to cut their prices at renewal. As I said, if there's competition on a good account, we're still going to see reductions, and there continues to be a difference in the underwriter's view between new business and renewals. But the whole market is no longer one of automatic cuts for the clients. Our organic growth, I think, shows great work by our team. We work in an incredibly competitive environment, as I said, and I'm proud of what we've done. Mergers and acquisitions, our second category of strategic growth. For 25 years, we've sought to attract the best firms in our industry to our company through the acquisition process.
The second quarter was a great merger and acquisition quarter. We closed nine deals, bringing $180 million of annualized revenue to the company. Our Heath Lambert acquisition in the U.K. brought us 1,200 new associates and $158 million of annualized new revenue. This acquisition fit our international growth strategy extremely well. You'll recall Gallagher had a modest retail presence in the U.K. market, which is the third largest retail market in the world. The Heath team is a great fit from a business standpoint, but just as importantly, the culture of the firm fit extremely well. We're excited to have our new teammates aboard, and already we're seeing that in many numbers of ways, our two organizations will be stronger together than we were apart. This acquisition adds additional strength to our global operations. We're building a much stronger international presence.
Remember, we've been trading with a network of independent brokers for many years. This has presented us with opportunities to continue to buy and/or take equity positions in brokers outside the U.S. Recall that over the last few years, we've expanded into the Caribbean, Australia, Brazil, Singapore, Canada, and the U.K. On the risk management side, we've been growing outside the U.S. since the mid-'90s in Australia, the U.K., and Canada. The fastest-growing part of our brokerage and risk management segments are our international operations. Today, roughly a quarter of our revenues and people are outside the U.S. Gallagher is building out a strong international platform. We're a global player with plans in place to continue our global expansion. Of course, you'll continue to see us be very active in the United States, but you will see additional activity outside the U.S., where two-thirds of the world's premiums are generated.
In our risk management segment Gallagher Bassett Services made great headway in the quarter, continuing with the integration of GAB Robins. The business has been consolidated. We've had excellent account retention. The change in offices and personnel is virtually complete. All the GAB accounts will be converted to our RISX-FACS system by the end of September. All in all, a very successful deal. As I say every quarter, all of these merger partners had choices. I'm glad they chose Gallagher. I think that's a testament to our culture, and I'd like to extend a very warm welcome to all of them. The next category is operational excellence and productivity. We worked hard on expense control again this quarter, and we continue to build out our service centers outside the United States. The progress I mentioned with the GAB integration also illustrates our success at operational excellence. And finally, our culture.
We continue to believe that our unique culture, based on teamwork, putting our clients first, and bringing new business in the door every day, is a significant strategic advantage. It's our culture that helps us attract new resources to our team and merger partners to our company. Our sales culture is very strong. We presently have about 150 interns learning about this great business, and we hope to recruit many of them as producers to our company. The second quarter is in the books. I'm always glad when the first half is over. We feel good about the first half of the year. I believe we have good momentum going into the second half of the year. We're on track to post more than $2 billion in revenue this year, which is a key milestone for our company.
We did our first billion, you'll recall, in 2002, our 75th anniversary. The exciting thing to me is that if you talk to our team, I believe that everyone would tell you we're just getting started. Doug?
Thanks, Pat, and good morning, everyone. Today, I have five comments. My first point relates to the Heath Lambert acquisition. You heard Pat say, and I certainly agree, we think this is a great deal for us as we expand internationally. To help you incorporate Heath into your models, on page four of the earnings release, we give you the standalone pro formas that we used when we struck the deal. As we integrate Heath and our other U.K. operations into one unit, it will be nearly impossible to track these operations on a standalone basis in the future. We won't be able to update that information in the future, but we hope it's helpful as you build out your models. Next, some voiceovers on the two nearly offsetting items related to acquisition earn-outs.
On one hand, we booked about $4.4 million of income as we adjusted downward our estimate of the amount that we will ultimately pay for the 2009 deal with Liberty. This accounting arises because in 2009, we estimated the ultimate earn-out obligation a little above the midpoint of the range, but now it looks like it will come in a little below the midpoint. Regardless of our estimates, this is really turning out to be a fantastic deal. It also illustrates why it was so important for us to put nearly 70% of the purchase price on an earn-out. On the other hand, we booked about $5.8 million of earn-out related compensation expense related to a different deal.
The $5.8 gets charged to comp expense rather than to goodwill because the sellers will, in turn, pay the earn-outs or a portion of the earn-out to employees that came with the deal. That gets recorded as comp expense, not goodwill. Moving to the corporate segment, my third point is an update on our clean energy efforts. We are making headway on getting three more operations that run our ChemMod technology and getting them their permanent permits. Those operations are in the same state that has already issued permanent permits for some of our other operations, which also use the ChemMod technology. We believe it is just a matter of time. In addition, nearly a dozen other states are granting or moving closer to granting permanent permits to other utilities to use the same ChemMod technology.
Many of these utilities would like to get plants into service prior to December 31st, 2011, thereby qualifying for federal tax credits. Accordingly, in the third quarter, we may consider building some additional plants. If we do, we will do it just like we did in 2009. We will build the plants and then quickly sell off about 70% of the plants, bringing our net cash in the plants down to a fairly modest amount. My fourth point is some modeling help for the overall corporate segment. For the second quarter, we posted results right in line with what I told you at the end of the first quarter. Looking toward the third quarter, we think you should just assume a repeat of the second quarter, and that will get you close.
As for the fourth quarter, again, model a repeat of the second quarter, but add $0.01 or $0.02 of profit for our clean energy efforts under the assumption we will get permanent permits for our other three plants. My fifth and final comment relates to the financial supplement we post on our website. Recall during the first quarter, we overhauled the supplement to present both reported and adjusted numbers for the last three-plus years. We believe conforming your models to follow that similar format will really help you see the true underlying comp and operating expense ratios and also other trends and seasonality of our business. Those are my five comments. In the end, it is nice to have a good quarter. Back to you, Pat.
Thanks, Doug. Bob, we are ready to open it up for questions and answers. Hopefully, 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're 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's *1 for questions. Our first question is coming from the line of Adam Klauber with William Blair & Company. Please state your question.
Good morning, guys. Thanks.
Morning, Adam. How are you?
Two or three questions. One on organic growth. What was the growth in international versus U.S., roughly?
About half came from international and half came from domestic.
Okay. That means that domestic actually did better this quarter than the last two quarters. Is that right?
Absolutely.
Yep.
Okay. That's great to see.
Domestically, we're in positive territory.
No, that's great. On Heath Lambert, that schedule you laid out is very helpful, Doug. What's the timing of the profitability? Will it take a while for it to ramp up next year? Particularly because the first half is pretty big for Heath Lambert, will the margin be pretty high from the get-go?
While it is skewed more to the first half of the year, it won't distort the margin that much compared to the whole year, Adam. It is a little bit more towards the first part of the year, but it won't really move the needle that much. In terms of the profitability, we lay out the integration costs for the next three years or two and a half years. We think by 2013, we put these two operations together, we think that both of the operations together could be approaching kind of our combined brokerage operation margins in total. We think there's further opportunity in 2014 versus these numbers here.
Okay. Could you give some detail, where are the cost cuts coming from?
Adam, this is a deal where we're really pleased with the people. There's more opportunity. If you really look at the comp and operating margins of Heath compared to our operations, comp is pretty well in line. Operating shows some opportunities. Most of the synergy savings will come from reducing operating costs, and it will come from additional London market commissions. The compensation line will probably hold in there pretty tight.
Thank you very much.
Thanks, Adam.
Thanks, Adam.
Thank you. Our next question is coming from Teague Sanders of Citigroup. Please state your question.
Hi, good morning, everyone.
Good morning, Teague.
Morning. Just had a quick question around organic growth, which was positive in the quarter, but it was kind of offset by some margin compression. Can you just help me understand the available leverage you guys have to kind of hold margins going forward and what we saw, why we saw the compression in the quarter?
First and foremost, when you look at the operating margin on three of 13, the adjusted EBITDAC margin, second quarter 2010 was 26%. Adjusted EBITDAC margin, second quarter 2011 is 25.4%. Just the margin dilution caused by the Heath deal caused 40 basis points of that differential. When you look at 25.4%, you understand that 40 basis points of that is lower because of the Heath acquisition, because of the nature of their margins. That gets you to 25.8%, and there's a handful of other little small items that eroded the other 20 basis points. Overall, even with the Heath dilution, year-to-date, we're actually up 10 basis points in margin in the brokerage segment.
Okay, great. Just a second question on the supplementals and contingents. Can you just kind of help us understand the drivers of each and just where we might see some lost revenue as we're seeing some of the underwriters experience some profitability decreases here?
If you look at page two of 13 in there, we show you that we actually continue to grow our supplementals. We think that the carriers are interested in doing that with us, and so we're using that. On the contingents, we're starting to see some of our contingents, especially in the wholesaling business, contract a little bit as loss ratios move up. Most of our wholesaling business is loss ratio driven, you can see it pull back. We were down about $1.8 million in the quarter. Year to date, we're down about $3 million. The lion's share of our contingent commissions are behind us for the year at this point. We might have a little pullback in the third quarter, fourth quarter, but nothing that's that meaningful that we can see right now.
Teague, this is Pat. There is a natural yin and yang here, and you're right to be thinking about this. When underwriters' results start to fade, these numbers will begin to change.
Got you. Okay, thanks so much.
Thank you. Our next question is coming from the line of Sarah DeWitt with Barclays Capital. Please go ahead with your question.
Hi, good morning.
Morning, Sarah.
I wanted to follow up about your comments on the pricing environment. Can you talk about what your view is on the sustainability of rate improvements, given that there's still a lot of excess capacity, and particularly if we don't have an active hurricane season this year?
Yeah, I think we all recognize there's good capacity out there. I think that what you've got is the CEOs of the insurance companies that I talk to often really do understand that they're at a point in the cycle that they've got good information systems. These are smart people. They know where they're making money and where they're not making money, and they're doing just exactly that, trying to hold the line. As I said in my comments, the simple fact is if you've got a good account with a good clean loss ratio record and one that is out shopping, they're going to see a reduction. It's just not going to be as great a reduction as it has been the last few years. I've seen this before where markets get spotty.
It's not unusual to see a line of coverage have a spike in terms of its hard market. I think you're going to see that with catastrophe property. There's no doubt about it. It's going up. Large schedules that are exposed to that stuff are going to pay more money, and we're seeing that right now. It's one of these places where I think the market is kind of in a spot where underwriters do know what they've got to do. Yep, there is an excess amount of capital. It's going to chase premium. That does put pressure on rates to go down, and we are seeing that. I would say that the rate of rate decrease has slowed considerably from what it was just a year ago.
Okay, great. That's helpful. Then can you talk a little bit about what you're seeing in terms of the acquisition pipeline and how big do you think you plan to get in international?
Well, right now, the international operations are one of our fastest-growing, I think we're beginning to see opportunities that we didn't before we built the platform. For instance, part of the Heath thing that's so exciting, number one, we got great teammates to join us. It's going to be a great franchise for us, it will allow us in the U.K. to do exactly what we've done for 25 years in the United States. We're already seeing teams of people and operations in the U.K. that are talking to us about wanting to come aboard. Bolt-on acquisitions in the U.K. can now become a better strategy in the retail side with the Heath platform. Two-thirds of the premium in the world is outside the United States, and we've been trading in that community for literally 40, 50 years and know a ton of people out there.
Just like in the U.S., many of these organizations, brokers outside the U.S., are run by baby boomers. Over time, families and individuals will seek to take some equity and some money off the table. They also are seeing a growing brand in Gallagher. Gallagher's a recognized international player, I think you'll see us continue to grow. Can international outstrip the U.S.? You asked about the merger and acquisition pipeline. It's absolutely stronger than it's ever been. We have hundreds of organizations that we're talking to. The merger and acquisition process is very much of a long-term sales cycle. We talk to people for years. They get warm to the idea. They come aboard. It's not like we open up a discussion in September and close the deal in October. That doesn't happen very often.
When you look at the brokerage world, there's 30,000 agents and brokers that we've identified, actually Hale & Associates have identified, in the U.S. alone. Most of these are run and owned, as I said, by baby boomers. The opportunity for us on the acquisition front, it's just never been greater.
Great. Thanks for the answer.
Thank you. Our next question is coming from Mark Hughes of SunTrust. Please state your question.
Thank you. On the risk management business, very good organic growth. How sustainable is that? Were there some specific upticks in business or contract wins that you're going to anniversary at some point here to make that a little tougher?
Mark, I think that if you look at the bottom of page three of 13, we intentionally break out adjusting fees related to international disasters. That relates mostly to the New Zealand earthquake situation. We believe that that's going to be around for 2011 and 2012. I think it'll be pretty well done by the end of 2012. That's why we broke it out last quarter. That's why we're going to do it going forward here. That number is great organic growth. I think it'll be something the team has to grow over by the time they get to 2013.
All right, we'll worry about that then. The claims frequency-
Well, we're worrying about it now.
Yeah. I understand. Finally, the claims frequency in risk management, the underlying workers' comp claims frequency, I am thinking here in the U.S. Any comments there?
We are seeing about 2% increase in our claim activity through the second quarter, which relates, interestingly enough, directly, I believe, to the economy.
Thank you.
Thanks, Mark.
Thank you. Our next question is coming from Meyer Shields with Stifel Nicolaus. Please go ahead with your question.
Thanks. Good morning, everyone.
Morning, Meyer.
Let me follow up on that last question, if I can. Are you starting to see companies retain more? We're getting at least some rhetoric about workers' compensation rates starting to turn upward. Is that affecting insurance buying behavior yet?
Not that we've seen yet.
Okay.
When rates go up in workers' compensation, it will, over time, push more people into the alternative market, and we'll benefit from that. There's no rush to the alternative market right now.
Okay. With regard to contingents, you fairly recently got back into the contingents game. I'm sorry, let me ask this differently. Is there any opportunity for new contingents that don't exist this year to be paid next year?
No.
Okay, you're at a full run rate.
Yep.
Lastly, talk a little bit about whether we're seeing any early signs, whatever, of specialty risks moving back to the specialty markets?
I would say no to that. I'd say that the market is still soft to the extent our wholesalers are doing a good job on what would typically be an E&S business. There's still probably some drag back to the standard markets from E&S, but it's slowed.
Okay. If I can throw in one more for Doug. You talked a little bit about incentive compensation in the brokerage business being down. Is there any such compensation in the second half of 2010 that we should adjust for?
Here's the thing, is that when you really stack it up, when you look at our incentive compensation, it's down a couple million dollars compared to the same quarter last year. On approaching a half a billion dollars of payroll as it rolls up, there's nothing unique in that. I don't see it as being something that's going to be different in the second half of last year. When I look at it, the second quarter of last year, we did pretty well, so incentive compensation was up a little bit more relative to this quarter, but there's nothing unusual in that. It just happens by the time you aggregate it out to be a couple million dollars.
Okay, great. Thanks very much.
Thanks, Meyer.
Thank you. Our next question is coming from the line of Alex Ducharme of Temujin Fund Management. Please state your question.
Hi, good morning. Just first a financial question.
I wanted to understand the trends in business insurance expenses. I noticed they were a bit of a headwind in the brokerage business and a bit of a tailwind in the Gallagher Bassett business.
Yeah. In the quarter, we did book a couple million dollars related to resolving, not a disagreement, a difference of opinion between us, a client, and a market.
I think that the thing there is every once in a while, you're stuck in a spot where you just better step up and do the right thing for the client.
Okay. Some of that was sort of a one-off expense in the quarter.
It was
Secondly, I just wanted to get some detail around the organic growth trends you're seeing in the brokerage business, specifically what you're seeing in domestic P&C retail versus wholesale versus employee benefits.
I think what you have to look at is the trend. All of them are improving. As a result, what I'm particularly pleased at, if you just look at our broad-based retail P&C brokers that have been fighting eight years of soft markets and three years, or almost four years now, of economic downturn, you're really seeing that starting to march forward. Pat said that we're doing a little bit better on new business. We're doing a little bit better on lost business. Rate isn't hurting us quite as much. That's still negative overall across the U.S. retail platform, but it's just nice, steady improvement that's reversing trends that we saw going negative, really from starting in about 2004. I think that it's just improving trends across all fronts.
While we're not seeing a large number of full-time employee growth in any of our businesses out there, I would say that we are seeing more stabilization in our clients' businesses. As I've said all along, we're a lagging indicator. We're going to get healthy when our clients get healthy, and they're stabilizing.
Okay. Thank you. I just wanted to go back to the business insurance question. Can you quantify how much was sort of a one-off in the quarter?
Compared quarter-over-quarter last year, you need to think about $2 million.
Yes, sir. Thank you.
Remember, anytime you have these type of things, you got to get them resolved, and they hit at different times, and we're going to have these things from time to time.
Okay. Appreciate it. Thank you.
Thanks, Alex.
Thank you. Our next question is coming from the line of Dan Farrell at Sterne Agee. Please state your question.
Hi, good morning.
Good morning, Dan.
Morning, Dan.
Doug, just a question on the clean energy ventures. You mentioned potentially making some additional investments in new plants. Can you comment on what the potential cash flows from those additional plants could be if you decide to make those investments? Are they going to be the small ones, those three that were already in place that are smaller? There are some others that are coming on that are larger. Just trying to get a sense of what the potential benefits could be.
I'm not at all prepared to discuss what the benefits could be at all because I don't have any idea about the demand for the plant. We're talking between one and 10 type plants. This isn't like 50 or 100 new plants. For us to build a plant, regardless of whether they go into a big location or a small location, for us to go through that first phase before the utilities and the monetizers take down, it costs $1 million-$1.2 million a plant, something like that. We're not talking about huge amounts of cash going out. Frankly, I don't know, but there just has been a change in the last 60 days that is saying that there's substantial demand for our Chem-Mod technology.
If we have to build some plants to get them up and running so they can use Chem-Mod, we'll look at that.
Okay. Just a numbers question on free cash at the end of the quarter. It was a bit higher than I would've thought, given the amount of acquisition activity that you had. Can you comment on any seasonality that might've been coming through, or are we looking at normal cash flow? Also within that $263, how much of that is cash that you could use today for acquisitions if you wanted to?
Spread around the world, we think there's probably $75 million of free cash in our balance sheet right now that could be used for acquisitions. That number's probably going to grow a little bit as we grow internationally, because I don't want to bring the money back to the U.S. and pay the additional tax they got it here. We'll probably let it sit there. If we can do deals in those jurisdictions where we have the free cash, we will. Otherwise, we may have some growing in our free cash balances around the world, but those opportunities will rise. We had some free cash flow in the U.K., we obviously used that.
Okay. Thank you very much.
Thanks, Dan.
Thank you. Our next question is from the line of Brian DiRubio with Y Capital Management. Please proceed with your question.
Morning, guys. How you doing?
Good, Brian. How are you?
Okay.
Good.
Doug, following up on that last question regarding where your cash is, thinking about your international expansion, what happens to your segment tax rates going forward? Should we expect them to trend down?
Well, I think that, like in the U.K., the tax rate is 27%, going to 26% for their-- you got VAT tax over there, and you got other things. I think the VAT tax doesn't hit the tax rate line. It goes through more the operating expense line, you still pay tax there, so it's not like it's any cheaper. You could have our tax rates moving a little bit lower in the brokerage segment as we increase our international expansion. Heath will bring it down a little bit, we're still primarily a domestic company.
Got you. Pat, for you, looking at the number of acquisitions that you've done, obviously the dollar amount too, all the employees that you've taken on, what's your bandwidth to do similar amount of acquisitions that you did last year second half, this year second half? Does that have to naturally slow down a bit?
Brian, that's a great question. Let me answer that in a little bit lengthy way. If you go back a number of years and you look at our acquisition activity, it was primarily driven by our PC retail operation here in the U.S. That was one team of people that were out talking to folks all the time and trying to bring about acquisitions. If you step back now and look at where we are today, we have our PC retail operation in the U.S. with an acquisition team doing very good work. We've got our wholesale MGA business in the U.S., which is doing acquisitions and has got a separate team and doing great work.
We have our employee benefits consulting operation that we have built out with acquisitions over the years, and they have a very good pipeline and a very good team of people doing acquisitions. Now, for the first time starting last year, Gallagher Bassett, our risk management segment, has proved that there are opportunities out there to bring others aboard and to consolidate them and have them work well. Our international activity is far more robust. If you really look back a decade, we've expanded our bandwidth by a factor of five times, and each of those teams are out constantly looking for the right private firms to join the company. I can't give you an idea of the number we're going to do or when we're going to close them, because it really is a long cycle sales process.
I can tell you that the activity we have in that area is great. If you take the Heath deal out, Brian, I think you'd see that we're kind of in line with what we've been doing in the past. You'd have eight deals, and it wouldn't be $200 million, it'd be $158 million less. Now I think that opportunities like Heath will come our way. Remember, Heath represents about 8% of our overall corporate revenues now. It's not a huge deal once you take a look at how the size of Gallagher today versus what we were just a few short years ago. I think the bandwidth has increased. The opportunities have also increased.
I've been saying over and over for years that the baby boomers are going to have to do something, and we're seeing a lot more activity in that regard, in particular here in the U.S. We are seeing people that are 59, 60, 62 getting to a point where they've got to realize their investment and their life's work. I'm very excited about where we sit. As I said before, you've got 36,000 or 30,000 plus of these in the U.S., thousands more outside the U.S., essentially there's five strategic players that are public players competing for them. We all have pipelines that are incredibly robust.
Got you. I may have missed this in the press release, I apologize if I did you guys use more cash in the M&A activity this quarter than you used to have?
Brian, the entire Heath deal was done 100% with cash.
Is that something you see doing more of? I know you have traditional mix, but with great flow.
We're okay. We try to target 25% cash, 75% stock, but if our cash flow is there, we will bring that number down closer to 50/50.
Got you. Final question, and this is sort of longer term, but tell me with Chem-Mod.
Chem-Mod is a tremendous product. We think that it's got great opportunity. Strategy right now is to penetrate those utilities that want to build plants by the end of the year using Section 45. We'll have plants in place that demonstrate mercury emission control. The mercury emission control law will go into effect as currently drafted in 2014. We think it produces opportunity. We'll have to sit down and do a strategic alternatives review of what we really want to do with Chem-Mod here after the first of the year. Our surge right now is to deliver Chem-Mod's technology to as many utilities that can put the plants in place by the end of this year. Next spring, we'll do a strategic alternatives review on it.
Great. Thanks a lot, guys.
Thanks, Brian.
Thank you. As a reminder, if you have a question, please pick up your handset and press star one on your telephone at this time. If you're in a speakerphone, please disable that function prior to pressing star one to ensure optimum sound quality. Our next question is from the line of Bob Glasspiegel, Langen McAlenney. Please state your question.
Good morning, everyone.
Good morning, Bob.
On the risk management segment, if we could dig a little deeper. Pat, your commentary and your EBITDA numbers are very impressive, yet the GAAP earnings are still way below where they were two to three years ago. When do the GAAP earnings sort of catch up to your enthusiasm?
As soon as we can get them there, Bob.
Right. Am I right that you are more upbeat about that segment than you've been in your commentary?
Yeah, I think that's fair, Bob, and I'll tell you why. The headwinds that GB has fought over the last few years are related in large part to claim counts and claims arising. As our clients' businesses began to falter, and you had the recession, when you go from three shifts to two shifts, you never like to see people get hurt, but there will be fewer claims to manage. We went through that at a time when the recession was very difficult. We'd also had a couple situations in previous years where we'd had some very nice bumps, some very nice wins that had a big impact. I think what you've got now in both businesses is a pretty good stabilization of the client base. Interesting developments in that space too, Bob, that make me more bullish.
If you take a look at the number of competitors there were just a year ago, and now the consolidation that's occurring, there's far fewer competitors that can actually take on a large self-insured account and adjust claims form across the U.S. There's even fewer if you want to add the U.K., Australia, and Canada to that mix. GB is growing to a size now where there are many markets out there that we do more claim work than they do. The expertise there, the ability to customize for the clients, the fact that competition is consolidating is just, I think, a long-term, very positive view. It's a business we've said we've liked for many years.
Okay. A softer question, if I might. You talk about culture being important and a real edge, and clearly as someone who's followed the company for a long time, I appreciate the asset that you have there. You talk about international expansion. Years ago, I think I remember you saying you were only looking at places that speak English, and I understand the distinction on your reinsurance sort of misstep where it was scale more than culture that got you off track on that. Does State Street go to other languages better now, or how does the Chicago culture go internationally broadly? Are we still talking English only, or are we more?
No, I think we've changed that, Bob. This year, again, we're very cautious in our acquisition activity everywhere in the world. Outside the U.S., we typically want to trade with somebody for an extensive period of time. Many of these are family businesses. They want to know the Gallaghers. They want to know what we're all about. They trade with us. In a number of the instances, the acquisitions we've done have actually secured a good trading book in the London market. We're very happy to take a smaller equity piece, let everybody get comfortable with each other. With the exception of Heath, most of our acquisitions outside the U.K. and the U.S. have been relatively small. You'll remember that we did an acquisition in Australia of SBA out of Perth. We took a 35% or 40% equity position.
We all agreed that we'd work together for three or four years, see how that was working, and decide if we wanted to go to 100%. We liked those folks, and they worked with us so well, we went to 100% much quicker than that. Great opportunity there for some young people to take over the operation. We've broadened that firm now into Sydney. Again, we'll be looking at more bolt-on acquisitions in Australia. We opened with a very small shop that we're pleased with in Brazil. As you know, we took a small position also in Singapore. I would say that we are willing to venture beyond English-speaking countries, we're also always cautious and want to know the people we're trading with.
What non-English-speaking countries that you're not in are the most attractive?
Central and South America.
Broader Asia is an emphasis?
Not right now.
Okay. Thank you very much.
Thanks, Bob.
Our next question is coming from Scott Heleniak, RBC Capital Markets. Please state your question.
Hi. Good morning.
Good morning, Scott.
Not to beat the international topic too much, but you guys mentioned that 25% of the mix by the end of the year being international. Where do you see that headed three to five years from now? Obviously, you've come a long way. Some of your peers are more like right around 50%. Could you see it getting that high, or where do you see that down the road?
I think we'd be glad if it was about a third of our business. Right now it's 25%, but our acquisition activity in the U.S. is ramped up very nicely. I don't think international will outstrip that.
Okay. Also on M&A, we noticed that just overall, not related to you guys, but just overall M&A deal activity in the brokerage space kind of dropped off a little bit in June and July. Based on your comments, it sounds like, do you think that's temporary, and do you think there's any change in sellers' appetites just because of, obviously, we've seen better pricing domestically over the past two to three months. Is there any change in sellers' mentality because of more favorable trends, people kind of waiting a little bit to see what happens?
No. No, we don't.
No. Okay. Finally on Heath Lambert, can you give what % of the business there is fee business?
I don't have that.
I don't have it right here in front of me, but let me see if I can find it. Let's go on to another question. I may come back to you on that while I'm looking for it.
Sure. The only thing, just broadly speaking, Heath Lambert, just wondering if you could touch on the kind of reception that you've had from clients and retention of accounts. Any kind of disruption, everything as planned?
Scott, I'll tell you, I'm really proud of the work our people did in terms of the early start to integration. The reception is beyond what we expected. First of all, you've got a company that was a large publicly traded company just a decade ago, that's gone through an awful lot of change in that decade to becoming a private company, exiting most of their wholesale work, becoming very focused on their U.K. retail, maintaining a very good brand in the market during that whole period of time. Yet being in a position where very difficult, couldn't do acquisitions, didn't have the cash flow for that, didn't have a lot of money to invest in almost anything. The management team, I think, did a really good job of building that company. I should actually say shrinking that company to a point where it was successful.
I think the hearts and minds of the Heath people really are embracing the Gallagher culture, the fact that we're a sales and marketing organization. This may not play well with the investment community, but they like the fact that they're working for a broker that's run by brokers. I think what we're seeing are tremendous number of teams that are sticking their toe in the water right now to see if Gallagher would be interested in having them join as a bolt-on acquisition or a team coming over. Clients have been, again, I felt very good about the way the clients react. I can tell you from doing acquisitions all these years, clients will react in line with the tone of the merged organization's leadership.
We've never done an acquisition and had full-scale revolt by clients saying, "We don't like that." If their account executive teams are happy and feel that it gives them more opportunity to serve the client, the clients are generally very positive embracing, and we're seeing that in England as well.
35% of it's fee.
Okay. That's all I had. Thanks.
Thanks, Scott.
Thank you. Our next question is from the line of Richard Mortel of Piper Jaffray. Please state your question.
Hi. Good morning.
Good morning, Richard.
Can you talk about the risk management segment? It looks like you're running into a 15% margin. How significant is the reinvestment there in terms of the margin? Are we talking 2%, 3%?
I don't know if I necessarily understand what you meant by the reinvestment, but let me see if I can answer the question. We try to target that business to run 15 points of EBITDA, and whatever they need to reinvest in the business, they do within the 15 points. It's not a real heavy CapEx business for us. There isn't a lot of reinvestment, if that's what you're talking about.
Yeah, I was just referring to systems that may be office build out, so I guess-
No, typically, we spend basically what we depreciate in.
Okay. The fees from the natural disasters looked like it was up a little bit from last quarter. How volatile is that going to be over the next four to eight quarters as that plays out?
I think it'll be pretty steady probably for the next four quarters, and I think you'll start seeing that ramping down in quarters five through eight following.
Okay. Thank you very much. That's all I had.
Thanks, Richard.
Thank you. Our next question is from Ken Billingsley with BGC Securities. Please state your question.
Good morning.
Good morning.
Just wanted to ask a couple questions, one on the corporate side. The two operations that you currently own 90% of, I know you say that there's no operating site for those. What's the, I guess, the annual cost of owning that, if there's no actual physical location for it?
Our CapEx in that, we spent $1.9 million on those two machines. That's what's sitting in the warehouse, and there's nothing to carry the cost of it until we get it in place.
Got it. It's $1.9 for both machines?
Yeah.
Okay. The other question I had on the letter of credit, the line of credit draw down about $35 million. Was that to fund Heath Lambert?
Our first quarter, as you know, is our seasonally lowest quarter, and going into the line has something to do with doing the Heath Lambert deal, and it's also just our first quarter is the lowest cash quarter we have. I expect to be out of that here, hopefully by the end of even this month.
Very good. Thank you.
All right. Thanks, Ken.
Thank you. Our next question is a follow-up from the line of Meyer Shields. This is Steve Nicholas. Please state your question.
Thanks. This is, I think, a big picture question that is probably difficult to answer, but if we start to see rates go up by 1%, is there any rule of thumb in terms of how much of those 100 basis points will fall to Gallagher's bottom line?
Remember what we've always said, if we have organic growth of negative 1% to positive 2%, something like that, holding margins would be good work for the franchise in light of inflationary pressures and new opportunities to do things. If you get one point of positive rate, we see rates still being down 3%. We'll see what the CIAB comes out with here later this week. Overall, if you get an incremental 4%, that if you assume that it all translates to the bottom line, and you take our three points of organic right now and add four more to it, and you get 7% of organic growth, you can get a good piece of that falling to the bottom line. Remember, we pay approximately 25% or to a third of our revenues to our producers.
There are some additional back office costs that do come along with increased volumes. If it's just rate and it doesn't produce a lot of additional work, it can be pretty high geared revenue that comes to us.
Okay, great. Thank you.
Thank you. We have time for one more question. Our last question is coming from the line of Mark Hughes of SunTrust Robinson. Please state your question.
Thank you very much. Any commentary on the employee benefits business, organic growth trends there, and any thoughts about the impact of healthcare reform on that business going forward?
Yeah, Mark, this is Pat. Thank you for your question. It's a good one. We've said all along that we were not in favor of that law. We still believe that the law is a nightmare for commercial America. We are the beneficiary of the difficulty in understanding the law. What we're seeing is a tremendous amount of questions from our clients relative to what the impact of this law is going to be. These are complicated calculations, and they're very complicated answers over many years. As you know, the regs themselves are not written yet, but many of the stuff that's in the law is already changing. You see McDonald's and others come up and want their mini-benefits plans to be approved, even though in the original law, they weren't. The point is, it's a moving target.
Our organic growth in our benefits operation is exceeding our property casualty and wholesale operations in the United States. I believe a large part of that is driven by the fact that clients now recognize they need a stronger and bigger player to help them navigate through the labyrinth of that law. We're picking up new business there. We're just seeing a stronger organic growth there, and I think it is driven by that law.
Thank you.
Thank you. Mr. Gallagher, I'd like to turn the floor back to you for closing comments.
Yeah. Thank you, Robin. Again, everybody, thanks for being with us on the call today. We appreciate it. Six months in, I'm pretty happy with where we stand. Our adjusted brokerage revenue is up 13%. EBITDA in the brokerage side is up 14%. Risk management, adjusted revenue up 19%, adjusted EBITDA up 14%. First six months, we've done 13 acquisitions, brought in over $200 million of annualized total revenue. Organic growth in the quarter, I think, speaks volumes for the sales culture. I feel good going into the second half of the year. Our board, as you know, reaffirmed our $0.33 quarterly dividend last week, and I believe 2011 is just shaping up to be an outstanding year. Thanks for being with us this morning.
This does conclude today's conference call. You may disconnect your lines at this time.