Good morning, and welcome to Arthur J. Gallagher & Co.'s third quarter 2010 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, please 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 securities laws, such as any observations regarding future results. 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, Rob. Pardon me. Welcome, everybody. Thank you for joining us on our third quarter conference call. I appreciate you being with us this morning. This morning, I'm joined by Doug Howell , our CFO, as well as the operating leaders of our operating divisions. I think our growth in the quarter continues to prove that our strategies for building the business are working. I was pleased with our quarterly results. I'll address both segments, our brokerage segment as well as our risk management segment. Let me start with the brokerage segment. Brokerage revenue and EBITDA are both up in what I will tell you continues to be a very, very challenging environment. I think we're making good progress. Rates continue to fall. If you look to the CIAB, that's The Council of Insurance Agents & Brokers quarterly survey, rates were down about 5.2% in the quarter.
We believe that the property casualty rates are now back to pre-2000 levels. With regard to exposure units, we think that we're really now seeing a kind of flat environment. We're not seeing exposure units growing to any extent. It feels like they're kind of not continuing to decline. As you can see on page two of our press release, organic revenues were flat in our brokerage business, which is an improvement over the negative 3% that we posted in the second quarter. A couple of things contributed to this, three things, actually. A number of good efforts around organic revenue. We had a good new business quarter, which I think is a credit to our sales culture. Everyone is out every day working hard to bring new customers aboard. Our retention in the quarter improved a bit.
We worked very hard to take care of our clients, and we expect them to renew with us. Our international operations contributed nicely. Our U.K. operations continue to show double-digit revenue growth, and our Australian operations are performing very well. Gallagher is clearly becoming a more global company. We closed 4 acquisitions in the brokerage segment in the quarter, and we're very pleased to welcome our new teammates to Gallagher. These firms all had a choice, and I'm very glad that they joined us. Again, I think this is a testament to the culture of the company. Our strategy is to bring our resources to the new partners and bring new sales opportunities to the company. Hopefully, one plus one can somehow equal five.
Merger and acquisition activity, by the way, is ticking up a bit in the fourth quarter as I think some sellers are wanting to complete before a possible tax change in 2011. We have a number of very nice transactions that we're working on, and we hope to close those before year-end. Our pipeline for acquisitions remains very strong. Our benefits team is working hard to help our clients understand the impact of the new healthcare legislation. We spent a considerable amount of time and effort to understand the law and to prepare timetables for compliance, along with frequently asked questions and calculators to show our clients and prospects how they will be impacted financially. This law is complicated, and it's going to keep our benefits consultants busy for some time. As an aside, our benefits teams are hosting various seminars and webinars regarding the new legislation.
At one seminar recently, when the sessions ended, we picked up three new accounts on the spot. This is complicated, and our people can help these clients navigate this. Let me move to risk management. You can see the impact of the economic times and the decrease in claim activity. It's a simple fact, fewer employees equals fewer claims. Revenues were down in the quarter and year-to-date, but I think our team has reacted very well to this by watching expenses and fighting to maintain what we believe are industry-leading margins. The real story at Gallagher Bassett in our risk management segment in the quarter was the completion of the GAB Robins transaction. We purchased GAB's contracts claims business. We're excited, and what motivated us in this regard was primarily twofold.
First, we added a number of terrific clients, which we're really proud to have the opportunity to work with. In fact, there's 200 new clients. Secondly, we added a very nice boost to our staff. We added 400 new professionals joining our company. This is a great shot in the arm for Gallagher Bassett. It's also a fact that in this business, scale matters. It yields cost advantages and efficiencies, and it enhances our ability to invest and maintain our edge over our competition. Integration is underway. We welcome our new teammates to Gallagher Bassett, and we hope they feel at home very quickly. Sort of a short synopsis. We're happy to have three quarters in the books. We plan on continuing our strategies to grow. Our cross-selling efforts are focused on paying dividends.
We're almost fully rolled out and will be by year-end on our sales management system. Our niche expertise continues to pay off in better account retention and new business, and our merger and acquisition teams are working hard on a strong pipeline. Doug?
Thanks, Pat, and good morning, everyone. You heard Pat comment on the operating environment. Like I did last quarter, I'm going to flip through the earnings release and highlight some items that might need some voiceovers, and then I'll move towards giving you some information that might be helpful in building your models. On the first page, you can see that we have broken out five items in an attempt to remove some of the noise in the EPS and EBITAC numbers. Items like book gains, severance, and lease charges are self-explanatory, so I'll focus on the other two items. First, in the brokerage segment, recall that accounting standard FAS 141R requires us to continually re-estimate our acquisition earn-out payables. In the third quarter, we revised slightly lower our estimated earn-out, primarily for the Liberty/Wausau deal.
To put this in perspective, recall that the earn-out could technically be up to $125 million. A slight change in an assumption or two changes the earn-out estimate by about $5 million. In my view, that's a net, so please do not jump to any incorrect conclusions. This continues to be a great transaction, and we're pleased with how our teams are performing. The second item is in the risk management segment. It's an expense related to settlement rather than extended litigation involving an employment matter. You'll see it flowing through the comp line this quarter because most of the settlement really relates to back compensation, not litigation expense, which would run through the operating expense line. For the next thing, turn to the last paragraph on page two. You'll read that our brokerage production and field management incentive compensation is up compared to the third quarter last year.
Because we posted better organic growth, in the third quarter, it became more likely that they will hit more of their thresholds in 2010 than we previously thought. That triggers a cumulative increase in bonus expense of about $4 million-$5 million here in the third quarter. Year-to-date bonus expense is consistent with 2009, it's just a third quarter catch-up item. All right. With that in mind, when you turn to page three and look at the brokerage-adjusted EBITAC table, if you adjust for that $4 million-$5 million bonus strengthening, it would make our third quarter brokerage-adjusted EBITAC margins about equal with the prior year. Again, you don't need to do that for the year-to-date margins because that's just a third quarter item. Turning to risk management, like Pat said, the big news in the quarter is that we bought GAB Robins.
We paid about $20 million for the business and assumed some runoff obligations. We think it's a great deal, and we think that we can leverage Gallagher Bassett's highly efficient infrastructure with very little additional fixed costs. In the next couple of quarters, don't expect much profit to hit the bottom line because we will have integration costs. By mid-2011, we hope to be up to an annual run rate of about $9 million to $10 million of cash on the deal. Okay, with those comments, let's move to some reminders as you build your models. First, when modeling supplemental and contingent commissions, please use note eight of this earnings release. For supplementals, use the adjusted supplemental commission line because that line puts 2009 and 2010 on a basis of how we think the supplementals will emerge in 2011.
For contingent, note eight also helps you understand the natural seasonality, and please bake that into your models. Second, when you make your picks for the change in estimated acquisition earn-out payable line, you should show an expense of about $5.5 million per quarter in 2011. This assumes we have no adjust to our estimates like we did this quarter. Third, for the corporate segment, it might be more helpful for you to build your models using the shortcut table we provide on page four and the information we provide on page five. If you assume that fourth quarter interest expense, M&A costs, and other corporate costs are similar to the third quarter, and you assume we make about $1 million after tax from our clean energy projects, you'll end up with about $0.06 to $0.07 of net loss for the corporate segment in the fourth quarter.
As a wrap-up comment, even in this difficult environment, the Gallagher team is working really hard to grow both our top and bottom line and bring operational efficiencies and higher quality to the business. All right. Those are my comments. Back to you, Pat.
Bob, we're ready for questions and answers.
Thank you.
Questions anyway.
Thank you. The call is now open for questions. If you have a question, we ask you to please press *1 on your touch-tone telephone at this time. We do ask all participants to please pick up their handsets while posing their question to ensure optimum sound quality. You may remove yourself from the queue at any point by pressing *2. Again, that's *1 on your touch-tone telephone at this time for questions. Thank you. Our first question is coming from Michael Nannizzi of Piper Jaffray. Please state your question.
Good morning, everyone. Congratulations on the quarter.
Thank you, Mike.
A couple of questions around some of your comments, Pat, in your initial remarks around the deal activity. Interesting that concern around the tax policy and that. Are you thinking ahead to the election this week and perhaps some of the noise coming out of Washington in recent weeks, just in terms of the tax policy maybe not changing as much as it has? Have you seen any sort of pushback at the table since some of those comments have come about?
No, we haven't. In fact, as I said, we're seeing activity tick up. I think activity for us over the last three quarters has been kind of slow, frankly. We've had people, I think, that are looking at both the economy as well as the rate environment, sort of playing a wait-and-see game. Just coming into the fourth quarter, we've seen activity tick up a little bit as people are saying, "I want to get this deal done." Don't know what's going to happen, obviously, with tax policy. Frankly, it would be good for us if the tax situation were to stabilize and not change. I think that our deal activity would be stronger in 2011. I think if tax policy does change and go back to the pre-Bush era, I think it will hurt our merger and acquisition activity.
Okay, anything around the bid-ask spread between, or I guess what you've seen over the past couple of quarters, any change there at all?
No, it's pretty stable, actually. Pricing, I think is stable. There are those people who believe their business is going to come back stronger at some point in the future that are holding off, yet we're seeing deal flow be pretty consistent right now.
Okay. Appreciate that. Also your comments around the healthcare bill and the unintended, I guess, benefit to Gallagher out of that law. Where are you in terms of thinking about your value add to clients along the way? Is it very early and there's still a lot more to work through? Can you expect more wins as you were highlighting here in this quarter?
Well, Mike, I've been very public in my statements that I don't believe this is a good law for America, okay.
Right.
Let me start there. This is a good law for Gallagher. If you don't have the capabilities and the talent that we have on our team, you can't compete right now. Our people have spent the time, the effort. We are doing e-learning exercises. All of our benefits professionals are being tested in terms of their knowledge of the law, that's happening right now. We're already on top of this. We're going out to meetings with our clients, both prospects and clients, I will tell you that the level of frustration by employers, I'm not talking huge employers, I'm talking that 100 to 500 life case. The frustration that they're beginning to feel with regard to this legislation is palpable, our people can really help them through this.
It's a wonderful time for us in terms of being able to get close to clients and to help them through what is a labyrinth of compliance and questions and timing and calculating the cost impact on them. This law is complicated, and we're the ones, along with very few others, that can really help our clients through this, and we're seeing the benefits of that.
It's just taking off then in reality for you.
Just now. It's taken off like a jet engine.
Okay. What about to the extent that maybe there is some reform on it that maybe lies ahead?
Well, again, it's one of these things I have to balance my answer. First of all, I'm not in favor of the legislation. I told our people that. We wrote to our senators and congresspeople and told them we didn't think this legislation should go forward. Not that we're not in favor of health reform. I can't speculate what's going to happen in the near-term elections.
Fair enough. Thanks very much.
Thanks, Mike.
Our next question is coming from the line of Bob Glasspiegel with Langen McAlenney. Please state your question.
Good morning.
Morning, Bob.
It seems, Pat, that the contingent commission is kicking in a little faster in 2010 than you had said going into 2010, which I thought it was, this is more a 2011 beneficiary. Is that a function of the underlying profitability in the business is better than maybe we thought, or that you're able to get the contracts to work more favorably sooner?
Well, one of the reasons we're breaking this out, Bob, is that we want all of you that are building models out there to understand that this is volatile income. Both our supplementals and our contingents are based on what we can negotiate year to year and the profitability of our book. The contingent income that you're seeing run right now has been stronger than we thought it would be, and it's primarily coming from our wholesaling operations.
Just expand on it. Is it because the business is more profitable or the contracts have gotten in sooner?
The business is profitable.
Okay. If we're modeling that, it's more a function of how the underlying business is doing than how many more new contracts you can write that have them?
Yes.
Okay. Doug or Pat, it seems like you hinted that the third quarter bonuses are higher because the growth is coming in better than you thought. Your commentary on the marketplace is not very inspiring. Can we pinpoint sort of where in the company things are coming in better than you thought in your budget?
Bob, yeah. We didn't hit the bonus expenses up. It's up $4 million-$5 million, first of all.
Right.
That is good work by the team of getting to the point of growing such that they can hit those thresholds.
Right.
You're exactly right in reading those tea leaves. In terms of where we see better organic growth than expected, it's kind of across the board.
Right.
I think that when you look at sequentially each of our regions, each of our units. Like Pat said, international is performing pretty darn well. We're seeing up and down the line improvement relative to where people were in the last couple of quarters. Nothing is standing out in one particular region or one particular unit.
Okay, last question. Pat, I'm sure you've had a chance to absorb Bill Berkley's sort of optimistic reporting of what is happening and what may happen shortly. Is he looking at sort of different lines of businesses than you are? Where do you think you and Bill, are company?
From his lips to God's ears.
Okay. I was hoping for a little bit more than that.
Well, man, seriously. I have great respect for Bill. I think he's a standout performer in our industry. He's a risk-taker. I kind of flow down the river. I go where the market goes. I'm not being facetious. I mentioned in my prepared remarks that we're seeing rates now that are pre-2000 level, those rates were not sustainable in 1999, I don't see any reason why they would be sustainable today. I look and say, this is my fourth cycle. I was a bad predictor of a change in the middle '90s, the market changed. I don't know when this market's going to change, but I can tell you, I'm pretty sure it will.
I'm with your reporting, Pat, for what it's worth. Thank you.
Thanks, Bob.
Our next question is coming from Keith Walsh of Citigroup. Please state your question.
Hey, good morning, gentlemen.
Good morning, Keith.
Hey, Pat, just first question. Exposures, I think clearly from your commentary, continues to incrementally get better, and I think that's pretty consistent what we're hearing out there. Maybe you could talk to, by geography a little bit. Is this a broad-based incremental improvement or, for example, Brown & Brown last week on their call mentioned the Midwest was particularly weak for them. If you could maybe talk to that, and I've got a couple of follow-ups.
I'll be glad to speak to it. I think we're seeing kind of a flattening, Keith, in terms of exposure units around the entire country. Internationally, we're seeing, I think, actual organic exposure growth. I had a chance last night to spend some time with a number of our young professionals that are out on the street every day, and it was interesting. We have a captive insurance company that we do for contractors. The people who are involved in infrastructure projects, I don't know about you, but it's hard for me to get to work in the morning with all the roadwork being done. Those people are up nicely. Payrolls out there look to be flattish, but not going down. We had one trucking client who is an intermodal client that moves stuff off the railroad tracks kind of early.
They've already had a good Christmas, which is interesting. Not a huge client. This is a client that has 65 units. Told us to expect that hopefully by the end of next year, they'll be up to 90 units. I think it's pretty broad-based around the country. We're not seeing the decrease in the Midwest that was mentioned on the Brown & Brown call. We're seeing flat here. I think it's pretty much flat in terms of exposure units across the whole U.S.
Secondly, just thinking about terms and conditions. I think with the competitive environment out there, I'm hearing just a lot of loosening by the underwriters on that end. Are your brokers out there basically winning much better terms and conditions for the client, basically at the same price, which I guess would be sort of a price reduction if we thought about it that way?
Yes. That's absolutely happening. I'll tell you that it's difficult for our wholesale business because the primary markets are taking business back away from the excess surplus markets. That's all terms and conditions, which it's a price cut by any other method.
Last question for Doug, just your commentary around the Liberty deal earn out. Help me understand why that isn't an incremental negative if the earn out is changing. What data point specifically led to a change in that earn out? Just so I understand it correctly.
I think it's purely a timing of their ability to cross-sell into the market. If they cross-sell more into their clients, and that happens outside of their earn-out period, so it takes them a little longer to get it, we don't pay as much for the business. In a way, it's a timing issue that's sliding it back more than it is a belief that there's any less capability of producing. Remember, this is a wide range from $0-$125 million, and we tweaked a couple estimates of the timing of when we think that they will fully mature into their cross-selling ability or adding products to their client portfolio, and that's what caused the change.
Does that change your accretion on that deal in any way, shape, or form?
No. I want to make sure. I think I may have had marble mouth when I said, expect the acquisition earn-out payable line to be $1.5 million per quarter next year. I just want to make sure you're clear about that. It doesn't change the accretion by hardly anything at all.
Okay, thanks a lot.
Thanks, Keith.
Thank you. Our next question is coming from the line of Mark Hughes of SunTrust. Please state your question.
Thank you very much. Good morning.
Good morning, Mark.
How about the claims frequency in the risk management business, especially in workers' comp? Any change this quarter?
We continue to see a slight decrease in claims activity. It really does. I said in my comments that fewer employees, fewer claims. Exposure units are flat out there. That means the employment situation has not improved.
Yeah. How about the rate of decline in frequency? Similar? Little less?
No, it's very similar.
You talked about a good quarter in terms of new business. Is that sustainable? Was there anything unusual, any special prizes this quarter?
No. In fact, there's no single big win that I could sit here and say, "Don't model that into the future." I really think our team is focused on getting new business, where they're doing a good job. We pound the street very hard, by the way, guys. This is not unusual for us, but we are out there every day trying to get new business on the books, and we just had a good quarter.
The U.K., Australia, I assume that's accelerating from prior periods. What's causing that?
That's a good question. I think the thing that's driving us in the U.K. are new teams. Remember, we did the First City acquisition in the second quarter, which is turning out to be a very good deal for us. In Australia, we completed the acquisition of the other 60% of the partner that we had in Australia that we didn't own, and they've done very well organically. Interesting. In Australia, they've actually piggybacked on the niches that we have here in the U.S. and done quite well using our expertise in some of the areas that we have in the U.S. to produce business in Australia. I think it's just a culmination of both the organic activity as well as acquisition activity.
Thank you.
Thanks, Mark.
Thank you. Our next question is coming from the line of Dan Farrell of Sterne Agee. Please state your question. Hi, Mr. Farrell, your line is open for question. Okay, we have lost Mr. Farrell's line. Our next question will be coming from the line of Meyer Shields of Stifel Nicolaus. Please state your question.
Thanks. Good morning. Let me start, Doug.
Morning, Meyer.
How are you?
Good. How are you this morning?
I'm doing okay.
Good.
It's raining here. The $1.5 million in anticipated acquisition earn-out payable increases, do I have that right?
Yeah.
That starts-
Per quarter.
Per quarter. That starts in fourth quarter of this year?
Well, here's the thing, is that it's been kind of consistent run rate at that since we did the Liberty deal. It's just it's masked in the last quarter or so because we had to make a change in the acquisition or an out payable adjustment also. If you assume that we have no further adjustments to our estimates, which is a little bit unlikely, you would have a normal expense running through 2011 of about $1.5 million a quarter. Remember, Liberty was primarily on an earn-out basis, so that puts a larger number on that line than we would get if we did smaller deals with only 25% on an earn-out.
Okay. No, that's helpful. I just wanted to see if I got the modeling correct. Two other questions, if I can. One, Pat, you talked a lot about the need for expertise in healthcare consulting because of the uncertainty with the bill. How common is the idea of employers just paying the penalty and dropping healthcare coverage from their benefits?
Actually, at this point, Meyer, it's pretty interesting. Not very much. Employers are looking at this as part of their comp cost and part of their recruiting efforts in holding their people. There's not a lot of activity. The bellwether in this is, if you go to our Massachusetts clients, we've not had a single commercial client just opt out and go into the Massachusetts plan. Employers are working their way through this. I'll tell you that the act itself is not making that easy. This is one complicated act. The compliance issues are huge. I'll also tell you that I don't think commercial America has really focused on it yet, because if you think about it, the only thing we've had to do is add the 26-year-olds to our plans as of September.
Various compliance starts to come in as we get into 2011, 2012, 2014, and 2018. I think you're gonna see a huge kickback from commercial America.
Okay. You're not worried about it impacting your revenues, I guess, either from that perspective or from the NAIC excluding it from the MLR calculations.
No, I think what we're seeing is an uptick in activity that is really. Again, I'm not in favor of this bill. Having said that, it's going to be very good for Gallagher.
Okay. Fantastic. One more question, if I can. Do you get that insurers are being too sanguine about inflation in their pricing?
Yeah, I do. I think that right now, and let's face it, they've had terrific results for a number of years. Yes, I think that the idea that inflation could be around the corner is not in the pricing at all.
Okay. Fantastic. Thanks so much, guys.
Thanks, Meyer.
Our next question is from the line of Brian Meredith of UBS. Please state your question.
Good morning, guys.
Morning, Brian.
I want to go back to the acquisition of GAB Robins. Historically, as far as my notes and history of the company goes back, you guys really have not done any M&A activity in that business. I know you made a small divestiture a bunch of years ago. Can you sort of talk about, is that a change in strategy for risk management?
No, it's not a change in philosophy or strategy. You're right, we've done a couple of small deals at Gallagher Bassett. Gallagher Bassett and our risk management segment has been all organic growth. We've grown this business over the last 25 years from literally $23 million to a half a billion. This was an opportunistic move, and of course, we will look, and we have over the years, looked at every deal that's come out in the business. This is one that really fit nicely.
This is something that you may see more of, or it's just sort of as they come along?
As they come along.
Okay. Doug, can you maybe give us some details, or will this be in the queue on Specialised Broking? Because we really didn't see anything because there was only a 40% minority stake when you made it in 2008. Can you give us some numbers around what the size of that business is?
Yeah.
On a pro forma basis.
Thanks, Brian. What Brian's referring to is we bought 40% of a broker in Australia a few years ago, and in the last quarter, we moved our ownership from 40% to 100%. It's a great broker in Australia. The leadership there is outstanding. This was as much about buying talent as it was about getting another footprint in Australia. Size-wise, the revenues are about $6 million. It's a highly profitable broker down there. This is more about the expertise in there. When Pat talks to you about how all of a sudden now we're importing some of our niche expertise into Australia, it shows you how us having a footprint there with some good leadership and a nice existing platform, can be a nice entrance into another market there. Been there for a long time, this really is a nice deal for us.
It's not financially that big.
Okay. Last question. You guys also have a minority interest in CGM Group Limited.
Yes.
I think it's 38.5%. That was done in 2007. Is that something that you can foresee, sort of cleaning up and taking full control, or is that dependent on the owners?
I think that deal has panned out to be a very, very good deal for both parties. Yes, when the opportunity presents itself, we consider ourselves going to 100%, for sure.
Yeah. I think it's illustrative of our international expansion opportunities there. I think that we want to put a toe in the water, find good indigenous leadership that is committed to do business the Gallagher way in these countries. I think both of these transactions are ways that I think that you'll see us growing internationally.
Great. Thanks a lot, guys.
Thanks, Brian.
Our next question is coming from the line of Adam Klauber with Macquarie. Please state your question.
First question on the GAB deal. Doug, I think you mentioned it could be profitable in the back half of the year. Will you be able to get GAB up to your traditional Gallagher Bassett models by the second half of the year?
Yes. These are great claim adjusters. These are great clients, and I think that everybody has received this transaction in a favorable light. People inside of Gallagher Bassett, people inside of GAB Robins are working very hand in glove in making sure that we continue to provide great service to our clients. I see this transition going similar to the Liberty deal. We had experience with bringing in 250 people in Liberty. We put them into 42 locations. In the Gallagher GAB transaction, there are 21 different locations. Some of those will join forces with Gallagher Bassett. Some of them will be stand-alone. We have a model of doing this, and I think the team will do a great job over the next six to nine months to get this thing in place.
Yeah, Adam. This is Pat. I'm very proud of what we've done in this regard. We've talked to virtually every client, and the feedback has been very, very positive. The feedback has been one that, look, we knew this company was owned by private equity, and we knew there was going to be a transaction that was going to occur, and we're very pleased that someone who strategically is interested in this business has picked up these clients. Right now, knock on wood, it looks really, really good.
Great. Do you think you'll have any charges in the first half as you try and improve profitability there?
I think that we should be able to absorb that in the profit stream of the company. I wouldn't say. You may have a little timing in it one quarter, but we're not talking about tens of millions of dollars of charges by any means. We might have $1 million or something like that here or there, but nothing that I would say would cause you to have a different outlook in the fourth quarter or the first couple of quarters.
Okay. One follow-up on organic. When you look at organic, went from negative 6 a year ago to a quarter ago, went from negative 3 to flat. How much of that improvement is roughly due to exposure improvement?
I think the CIAB is correct, Adam. I think that our rate situation is down five points. I think that probably 4% is, in fact, exposure.
Okay.
Two and a half to four.
Great. Thank you very much.
Thanks.
Thanks, Adam.
Our next question is from the line of Jay Gelb of Barclays Capital. Please state your question.
Thank you and good morning.
Morning, Jay.
How are you?
Good.
First, to follow up on the last question, if organic growth is probably flat to higher from where it is at current levels, what does that imply for the potential for margin improvement?
I want to make sure I give this as a balanced response. I'm not predicting which way it's going here. In a down organic market, the franchise, it'll be great work to hold margins flat. In a flat organic environment, you might see a slight margin expansion, but probably not enough to change your models too much. In an organic growth environment, in a little organic growth, there'd be a little margin improvement. In a big organic growth margin, more will fall to the bottom line. There's a full spectrum of possibilities, all depending on which way our organic growth goes.
Okay.
I'm not prognosticating one way or another.
Right. So far this year, Gallagher has basically kept the margin flat to up modestly. Seems like there'll be less of a headwind going forward. The other thing I just wanted to touch on is the ability for Gallagher to capture increased core commissions from the markets on an agency basis. Can you talk a little bit about that?
I'm not clear on that question, Jay. Will you redo it for me?
Sure. In a soft market, typically, we might see the carriers paying increased commission rates.
Okay
In order to attract or retain the business. First, is that the case? Second, what kind of traction are you having there?
The good news is for us, is that by and large, our production teams are paid based on what they bill. At the underwriting desk, to get a deal done, we empower our producers to do what they need to do. They can cut commissions, and they can ask for more. In a soft market environment where there is decreasing pricing and there's plenty of market around to do a deal, our people will typically do better on their core commissions, and we are seeing that.
All right. Seeing higher commission rates as premiums fall.
Let's put it this way. Our producers are essentially getting the commission rates that our contracts call for.
Can you clarify that? I'm not sure.
Yeah. The bottom line is we're not having to cut our commission rates to get deals done. In fact, we're typically asking for more commission where available to produce business for the market.
Makes sense. Okay. Thank you.
Thanks, Jay.
Thanks, Jay.
Our next question is coming from the line of Scott Heleniak with RBC. Please state your question.
Hi. Good morning.
Good morning, Scott.
Just wondering on M&A, are you seeing more competition for employee benefits acquisitions? I know everyone's sort of a hot spot lately. I'm just wondering if you're seeing a difference. Is that impacting your strategy or your ability to close deals there?
We are seeing more competition. No, it's not impacting our strategy. One of the things that I think gives us a leg up in the acquisitions, in particular in the employee benefits space, is the fact that we've built tremendous expertise in that business. We've diversified away. We're not just a health and welfare broker. We've got all kinds of expertise in different areas that helps these new merger partners cross-sell more things to their clients. If you think about the typical insured out there, they're not just buying health insurance. There's all kinds of voluntary products. There's life insurance, 401(k), retirement, et cetera. We bring expertise in all those areas. It gives us an opportunity to expand the relationship with the companies that join us through the merger and acquisition process. Yes, there's competition, we're not seeing pricing tick up.
It's not changing our strategy in the least. We continue to build out that platform. That's a business that has grown extremely well for us over the last decade.
Okay, thanks. Just one more question, too. You guys have done a nice job the past couple of years with the expense controls, just wondering if there's any expectation for changes in expenses in 2011. Just wondering if there's any additional renegotiation of leases or anything left, or how are you viewing expenses heading into 2011?
Yeah, Scott, good question. I think that in terms of expenses, let's take it a couple different places. I think there's opportunities still in the real estate space. That's kind of a slow creep that comes through as we're not going to rush out and do a wholesale reset of our leases at this point. We're having a lot that we'll renew, and we'll look at them differently, and I think there's some savings there that we can harvest there in 2011 and 2012. When it comes to just consumable expenses, we buy our pens and pencils and phones and everything else pretty cheap at this point, our furniture pretty cheap, I wouldn't expect much more savings there. On our travel expenses, you're seeing natural inflation out there with the airlines, that's causing an uptick in expenses.
Our people are traveling more to see their clients and more to do internal meetings in 2010 than they did in 2009. That uptick is already in the numbers. Would I think there's a big uptick coming in 2011 in those expenses? Probably not. I think holding it kind of steady to 2010 levels in 2011 is about where we're going to be. The place to look for opportunities is primarily in the real estate spot, and I don't think you'll see much slippage unless you get inflation in all consumables, then that's what you would see.
Okay. That's all I have. Thanks.
Thanks, Scott.
Thank you. If you have a question, we ask you to please press star 1 on your touchtone telephone at this time. Our next question is from Dean Evans with Keefe, Bruyette & Woods. Please state your question.
Thanks. I think most of my questions have been answered at this point. I was just wondering if you could go into a bit more detail. Initially, when you were talking about the organic improvement, you did reference both new business and retention.
I was hoping you can give a little more color on those. Hopefully, if you'd be able to give us the numbers for the quarter and what they were last year, that would be great. If not, really just a little bit of a discussion around what's happening there.
Well, Dean, let me give you the discussion, not the actual numbers. I think, you've seen this from our results in the past, that we tend to ebb and flow, and sometimes we're better on new business than we were in previous quarters. This just happened to be a good new business quarter for us. I think that's probably saying something like 2% better than what we've done in previous quarters. I'm not sitting here telling you that organic new business has jumped 10 points because we've done something magnificent. I just think we had a good quarter of blocking and tackling and getting the job done. Same is true when it comes to retention. Some quarters, I think we mentioned in the second quarter that we'd had one or two lost accounts that kind of hurt us.
This quarter, we had better retention than we'd had in previous quarters, it all added up. Add to that our organic as well as M&A growth internationally, we come out flat, we're happy with that. That's an improvement over where we were the last six months, actually. I'm sorry not to give you the specifics. Here it is. This is what the numbers are. That's kind of the anecdotal thing, what's happening. What's my feel as we go forward? My feel is that exposure units are kind of flattening. We're not seeing the decrease of people coming to us saying, "My payroll is $100 million. Take this thing down to 50 for my renewal." We've lived through that. That is exactly what was happening a year ago.
People are saying, "Look, my business is going" We had contractors doing $100 million of revenue going to $15 million. We're putting out just as many bid bonds. They're bidding jobs they never would have bid. We're issuing certificates of insurance and working our tail off to keep that client who used to pay us X and is now paying us X minus a lot. It was just a better quarter in that regard.
Okay. That is helpful commentary. Trying to think about it, I guess, from the more positive side, is there a chance that that X minus whatever gets back to X in the near term-
Yeah
Improves from flattening?
Yeah. I think there is. Again, these are all anecdotal stories, but having a chance to interact with our people that are on the street dealing with individual accounts. If you're in the home building business, if you're in the artisan contractor business, you're still going down. It's going down big time. If you're infrastructure, if you're transportation, some of these other businesses, retail, we're seeing a little bit of growth there.
Okay. Thank you.
Thanks, Dean.
I guess lastly, and kind of a quick one, but definitely we've seen a handful of things like a litigation charge over the last few years. Is there anything pending that you can think of that's sort of a one-off type item that's going to be coming through over the next few quarters or?
Dean, that's a great question. Yeah, we've had a couple in the last couple of quarters, and I think that's great work to the legal team. We've cleaned up some stuff that's been hanging out there for a number of years. I don't see anything on the horizon right now that's brewing. I think we've got kind of a clear slate in what we're seeing. Naturally, litigation is a part of every business' issue that they've got to face, but I think we're in really good shape right now, and it's great work to the team.
Okay, perfect. Thank you.
Thanks, Dean.
Our next question on the line of Alison Jacobowitz of Bank of America. Please state your question.
Hi. Thanks. Most everything's been hit on, but I was just wondering maybe if you could talk a bit about what you're seeing in the captives.
Yeah. Good morning, Alison.
Good morning.
It's interesting because I had a chance to chat just last evening with some of our people that are actively involved in captives. The captive clients, by and large, continue to be very happy with the fact that they're in a captive. I'm speaking now about our group captives. Single parent captives are very stable. Group captives are hard to sell new business into right now because you have to make a capital contribution, but we are seeing a very stable renewal book. They typically come into a captive, and they don't leave. The renewals on these captives have been very successful for the captive clients, and frankly, prices are down substantially. Many of them have been good to us in the sense that when we've taken their cost down substantially, we've been able to actually get them to keep our remuneration pretty flat.
Thanks.
Thanks, Alison.
Thanks, Alison.
Our next question is from the line of Dan Farrell of Sterne Agee. Please state your question.
Good morning, guys. Sorry about earlier. I accidentally hung up instead of unmuting.
That's okay, Dan. Welcome to the call. Welcome back.
Good to get back. I apologize if any of this has been addressed. Just on your free cash that's available for acquisitions, can you tell us where that stands post-GAB? Also, I think some of your unrestricted cash. If you could do an exit carrier revenue, what you could actually put to deals.
Dan, good question. We've got about $80 million that we could do a deal with right now in free available cash.
Okay. Then is your view still to use on a go-forward basis about 75% stock, 25% cash, or is that changing in any way?
That's our go-in. Obviously, we'll always use the cash up first before we use the stock. Right now, I think that we've got some pretty good flexibility in our M&A pipeline with $80 million in the bank right now. Plus, we've got a $500 million line of credit, too.
Okay, great. Thanks. Could you just talk a little bit about trends that you're observing in the wholesale and MGA environment versus traditional retails?
Sure. On the MGA side, one of the things that drives that business is startup businesses. We're seeing a little uptick in startups. A year ago or so, we would've told you, and I think we did, that startups just weren't occurring. On the MGA side, we're seeing a little bit of uptick from new startup businesses that come into our various MGAs for coverage needs. The wholesale business is very tough. The open market broking business is tough. The primary carriers are, in fact, they do have appetite. Retail brokers would prefer to push their business with primary carriers because they get more commission. That business has been tough, and prices continue to come down. That's a business that is our most cyclical business. We understand that it's cyclical, and I think we've built a real powerhouse.
We trade in that business in the U.S. as Risk Placement Services, and Business Insurance has got us rated now as the number one MGA open broker wholesaler in the business. I think that there's very good future growth there, but it's tough slogging right now.
Okay. Thank you very much.
Thanks, Dan.
Thank you. Our last question is coming from Meyer Shields, Stifel Nicolaus. Please state your question.
Thanks. Just a couple of quick follow-ups, if I can. One, we saw an uptick in the gains on book sales. What annualized revenue is associated with that's been sold?
Yeah, actually, you'll notice we call it book gains and other. Most of that in this quarter came from when we bought the remaining amount of the Australia broker. We went from 40% to 60%. It produces an accounting gain on that purchase of about $2.5 million-$3 million. There wasn't really much book sales in the quarter. It's just we have this unusual accounting situation. When you move from a minority position to a wholly owned subsidiary, it creates an accounting gain, and we put it in that line item. There wasn't that much in this quarter, Meyer.
Oh, okay, good. With regards to GAB Robins. If I understand what you were saying before correctly, Doug, then we should expect really not much incremental earnings over the next three quarters, and then ultimately margins should get back to legacy Gallagher?
No. I gave no opinions or comments on margin of the blended two organizations. What I said is that if you model in the $45 million-$50 million of revenue that will come from the GAB Robins, eventually that'll throw off $9 million-$10 million of earnings.
Okay. Would you care to comment on margins?
Put it this way. It's pretty easy to do the math. If you take Gallagher Bassett at $450 million at 15% or 15.4% where they are right now, and the GAB Robins and put them together, you'll get some margin expansion on it. I don't have it right here in front of me.
Okay, fair enough. Last question. When you were talking about the acquisition pipeline, is that basically still primarily domestic?
No. In fact, I'd say over the last five years, that's not been domestic. As you know, we did the First City deal earlier this year in the U.K., added a significant FinPro practice to our organization in the U.K., and that has been a very successful acquisition. We completed the deal in SBA in Australia. We did a small acquisition in Brazil. We're presently looking at a small deal in Singapore. Our aspirations are global.
Okay, great. Thanks so much, guys.
Thanks.
There are no further questions at this time, gentlemen.
Great, Rob. I'll make a few just closing comments if I could. Thank you everybody for being with us this morning. I really appreciate it. As I said, I think one of the reasons we've been able to keep growing, even in these difficult times, is because we've kept very strong focus on our strategies. We're sales focused, working every single day on organic growth. We're recruiting great talent. We're attracting merger partners that we're pleased to have join us. We are expanding globally, and at the same time, we continue to fight tough headwinds. The Gallagher team is focused, selling, winning, and growing, and I'm proud of that, and I'm proud to be associated with these performers.