Arthur J. Gallagher & Co. (AJG) Index Membership: NYSE COMPANY PROFILE
17 November 2004
Gallagher provides insurance brokerage and risk management services to a wide variety of commercial, industrial, institutional, governmental and personal accounts through out the United States and abroad. Commission revenue is primarily generated through the negotiation and placement of insurance for its clients. Fee revenue is primarily generated by providing other risk management services including claims management, information management, risk control services and appraisals in either the property/casualty (P/C) market or human resource/employee benefits market. Investment income and other revenue is generated from Gallagher’s investment portfolio, which includes fiduciary funds, equity securities, and tax advantaged and other strategic investments. Gallagher is headquartered in Itasca, Illinois, has operations in nine countries and does business in more than 100 countries globally through a network of correspondent brokers and consultants. INDUSTRY ANALYSIS: Porter’s Five Forces
Overall industry rating: Threat of new entrants. Bargaining power of buyers. Threat of substitutes. Bargaining power of suppliers. Intensity of rivalry among competitors. X X X X Unfavorable (high) Moderate Favorable (low) X
Although Arthur J.Gallagher is the worlds’ fourth largest insurance brokerage in terms of revenue, it is still much smaller than its two largest rivals. It caters to middle-market insurers and allows it’s two biggest competitors, Marsh and Aon, to maintain most of the market share of large accounts. With this in mind, it plans to market heavily to the midmarket group this coming year. Gallagher avoids going head-to-head with the big guys by specializing in more than 20 individual insurance niche markets, such as aviation, construction, governments, and nonprofit groups. Since 2000, insurance premiums have been on a steady rise. This translates well for AJG revenue because the company receives a percentage of all policy premiums Threat of New Entrants: On economies of scale, AJG has significant capital and is one of the largest players in the industry. It is a long established company and has already overcome initial capital requirements. It has many favorable locations and has the intangible asset of its name brand. It has differentiated itself by offering policy analysis
for industries such as construction, real estate, non-profit, and government. Threat of new entrants is still feasible because of the low risk involved with offering brokerages riskmanagement services and the small amount of capital needed to start a company in a regional area. AJG does have entrenched acquisition channels for getting good insurance products, whereas a startup company does not. The industry will have many clients floating around after the Marsh/Aon suits and smaller companies can take a piece of the market share if AJG does not hustle. In 2003, AJG acquired 14 companies. This is in addition to the 10 acquired in 2002, and the 13 brokerages and 3 consulting firms purchased in 2001. The industry will be facing many lawsuits in the coming year related to conflict of interest in contingent commissions, which are commissions paid by insurers for recommending certain products. The competitors in question are Aon and Marsh. This could bring more clients to AJG atop the aquired companies. Insurance is insurance. There are not many substitutes for it and many mid-market businesses must insure their risk and assets. New ways to manage this risk may come online but this is not likely. The bargaining power of the companies is decent because any company can go to another insurance brokerage and get the same analysis. Small differences in the policy products will determine where the client goes. AJG, or any similar company can charge a smaller fee or commission for their services in an effort to obtain clients, this is why the bargain power of the supplier is medium. Insurance brokerage, unlike insurance underwriting , does not require much capital to be lucrative. It also does not involve taking on the risk of insurance policies and claims. Brokerage simply assesses the risk and suggests effective policies plans at the best rates. In general, brokerages tend to have little debt because they are not financing such claims. AJG, however has guaranteed some of its subsidiaries for loans, increasing its risk slightly if subsidiary companies default. Two-thirds of AJG’s revenue comes from insurance brokerage, the last third of revenue is reinvested and managed in tax-advantaged ventures such as, coal substitute plants that are subject to tax write-offs for alternative energy and low-income housing. GROWTH Segmental Results: Brokerage Total Revenue growth: $241.4million (3Q 2004) from $222.3 million (3Q 2003) 9% growth 12% growth (3Q 2003 from 3Q 2002) 9% growth (9 months 2004 from 9 months 2003) 16% growth (9 months 2003 from 9 months 2002) Comparing previous quarters this year: 2nd Q: 11% growth (record earnings) 1st Q: 9% growth (record 1Q earnings) Greatest absolute increase in commissions, but greatest percentage increase is investment income at 71%. Total expenses: $184.9m (Q304 from Q303)
$167.4(Q303 from Q302) 10.5% growth Amortization made up greatest percentage increase in cost, 68% in Q3 compared to previous year Q3. Due to number of acquisitions (see sources of growth).
Risk Management Revenue made up of fees, small amount of fiduciary investment income • 44% growth in earnings per share. • 14% growth in revenues, all of which is organic. Total revenue growth: 16% in 3rd quarter of 2004 2nd Q: 19% (record earnings) 1st Q: 15% (record 1Q earnings) Total expenses $78.8m from $71.7m, 10 % increase Operating and compensation costs growth are high, around 7%-14% compared to previous quarter and the nine month period. Financial Services (management of Gallagher’s portfolio): Revenue growth in 3rd quarter : $36.9m from $37.9m, fall of 2.6% Consolidated investments 347% increase from 3.2million in 2003 Q3 Comments on Growth: All three sectors are performing quite well. Based on this year’s trends, total growth is likely to be sustainable but it seems to be slowing down. For the two main sectors Risk Management and Growth, growth rates healthy in reference to 2003’s 3rd quarter but these have slowed down since the 2nd quarter of this year where they were enjoying higher growth rates of 16% and 11% respectively. Risk management revenue growth increased the most out of all three sectors this quarter with 14%, while Brokerage was rather high as well with 9% growth. Financial services is still a small department and it experience a small decrease of 2.6% in revenue. $94.7million was earned from the Risk management sector while $241.4 from the brokerage sector. Risk is growing at the greatest rate but is still far behind Brokerage in terms of proportion contributing to the total revenue of the company. In the large Brokerage sector, Commissions is still the greatest contributor and its recent high growth may imply that commissions in likely to increase, albeit at a slower rate. Also investment income is increasing by a high percent but is rather small still so percentage calculations are not very significant. On the cost side, amortization is taking up some amount in the Brokerage sector of 68% compared to Q3 2003. Sources/Quality of Growth: Acquisitions During 2003 and 2002, Gallagher acquired 14 and 10 companies, respectively. Crucial issue for acquisitions is quality of integration. On this count, while amortization of goodwill will hurt earnings to some extent, from a long term viewpoint, there is no sign that the acquisitions have gone badly.
Gross revenue per employee increased from $155000 to $181000 New Markets Brokerage Services Retail Division’s (BSD) niche strategy of creating dedicated, cross-divisional teams with expertise in specific industries or lines of business Higher Education, Mergers & Acquisitions; Agribusiness; and Habitational and Shopping Center. Niche revenues grew at a faster pace than general retail brokerage business in 2003 Organic Growth Overall market conditions Will continue to benefit from high premiums. This may be unsustainable. How long will this last? Its too complex a question for us to answer due to the political issues involved. STRATEGY General Due to the immense number of companies in the AJG group, it is impossible to discuss every single strategy. These are some of the more coherent and consistent strategies in the group. Acquisitions Acquiring new companies as a way of expanding or entering new markets/niches. Niches/Focus Entering into niche markets instead of fighting in oversaturated markets. Focusing on certain specialized areas in the market. Cross Selling Gallagher Bassett Services (GB), is the world’s largest multiline third-party administrator Chances for cross-selling between BSD and GB Worldwide Cooperation Expansion of our Worldwide Risk Services Group, which provides support for multinational business development to producers and branches throughout the BSD Retail network. Address clients’ needs throughout the world and pursue new business opportunities together Service PROFITABILITY: The company shows consistent net margins. Net income and EPS have shown consistent growth, though this is somewhat erratic. It was great for the 2001, very sluggish during 2002, and returned to just below historically normal rate of growht in 2003. If you break down the numbers further, you can see that before tax earnings in 2001 were only 6% higher than before tax earnings in 2000. Tax income growth has thus been included to provide a clearer picture, and it indicates that earnings growth has been erratic. The dramatic increase in net earnings can be explained by the fact company paid much less in taxes in 2001 (paying 11% in taxes while versus paying on average over 30% for the other 4 years). This was due to a large tax credit its financial services division received for investments in alternative energy ventures. This, however, is a consistent strategy by
AJG to reduce tax incidence. Earnings growth was also clearly hurt by the recent recession. But after rebounding in 2002, it has fallen once again. Both return on equity and return on assets have been on a downward trend that started before 1999, (aside from the spikes in 2001). The leverage ratio is much higher than 1, as is expected for a financial institution. AJG has better ROA, ROE, and quarter on quarter EPS growth than its competitors. Net margin is comparable to its competitors. Finally, cashflow increased significantly in 2003, probably due to a recovery from previously sluggish growth in 2001 and 2002. Profitability Ratios: Arthur J. Gallagher Net Margin Net Income (% Growth) Before Tax Income (% Growth) EPS (% Growth) ROA Financial Leverage ROE 1999 11.90% 83,200 (16.54%) 127,000 (20.81%) 1.02 (14.29) 8.91% 2.75 32.97% 2000 12.01% 93,000 (11.78%) 133,700 (5.28%) 1.11 (8.82%) 6.90% 2.38 35.66% 2001 11.82% 125,300 (34.73%) 141,800 (6.06%) 1.48 (33.33%) 7.70% 4.77 38.01% ROA 5.93% 2.32% 3.78% 2002 12.25% 129,900 (3.67%) 185,500 (30.82%) 1.49 (0.68%) 6.06% 3.66 34.96% 2003 11.57% 146,200 (12.55%) 193,300 (4.20%) 1.63 (9.40%) 5.93% 3.68 27.68% ROE 27.68% 13.96% 31.27%
Profitability Comparisons: Company Net Margin Arthur J. Gallagher 11.57% Aon Corp (AOC) 6.40% Willis Group (WSH) 19.94% Cash Flow Metrics (in $1,000s) Arthur J. Gallagher Cash from Operations Capital Expenditures Free Cash Flow FINANCIAL HEALTH
5 Year EPS Growth 15.69% 7.27% 5.28% (TTM)
Financial Leverage 3.68 5.00 7.28
1999 72,955 17,000 55,955
2000 136,229 14,568 121,661
2001 130,309 24,319 105,990
2002 149,683 45,430 104,253
2003 229,000 25,300 203,700
Financial health of AJG is good, and has improved steadily over the years. Debt to equity is very low, and has improved over years. Interest Coverage has also improved since 2001. Before that, debt was very small; hence the large number in 2000. Current ratio has remained steady, while quick ratio, though down from 2002, is still relatively stable. When comparing AJG against her competitors, we see that AJG seems more conservatively run to some extent. Debt to Equity is far lower, as is Interest Coverage. Current Ratio and Quick Ratio are comparable, though WSH has a higher Quick Ratio.
Arthur J. Gallagher Debt to Equity Interest Coverage Current Ratio Quick Ratio Company
2000 0.32 44.2 1.06 0.50 Debt to Equity (MRQ) 0.19 0.61
2001 0.26 14.5 0.95 0.40
2002 0.24 20.5 1.01 0.76
2003 0.20 25.2 1.02 0.71
MRQ 0.19 28.2 1.00 0.7 Quick Ratio (MRQ) 0.70 0.70 0.9
Interest Coverage (MRQ)
Current Ratio (MRQ)
Arthur J. Gallagher 28.2 1.00 Marsh & McLennan 10.5 0.80 (MMC) Willis Group (WSH) 0.33 19,8 1.00 Source: www.smartmoney.com. Historical data from Annual Reports Times Interest Earned = EBIT Current Ratio = Interest Expense
Current Assets Current Liabilities
Quick Ratio = Current Assets – Inventories Current Liabilities VALUATION COMPS Arthur J Gallagher (AJG) is reasonably priced if compared to Willis Group (WSH). Compared to Marsh & McLennan (MMC), however, AJG seems overpriced. It must be noted, however, that Marsh and McLennan’s earnings were far lower ($0.04) for the most recent quarter as compared to a year ago ($0.65). This may have caused a drop in price, though I am speculating at this point. The one area, however, where AJG is consistently overpriced seems to be in the P/E and PEG. That said, the stock seems fairly valued. Company Price/Book Price/Sales P/E (Price) AJG ($29.88) 3.6 2.0 14.98 Marsh & 2.6 1.2 12.02 McLennan (MMC) ($27.53) Willis Group 4.3 2.7 14.28 (WSH) ($37.01) All values TTM; source www.smartmoney.com The Bull Case: Stable company with good fundamentals and good earnings. Has growing dividend and compares well against competitors. Net earnings increased for every year since 1991. Low current PE (14.98) compared to 5 Fiscal Year PE Range (14.6 – 33.51), albeit partly due to litigation risk. Rising productivity amongst workers (Gross Revenue Per Employee increased 16%) indicates all the acquisitions have been relatively smooth. Growing quickly through acquisitions. PEG 1.16 0.99 1.09 Price/Cash 12.3 14.5 N.A. Dividend Yield 3.18% 4.64% 1.93%
The Bear Case: Part of growth based on premium rate hikes due to terrorism: this may not be sustainable. Earnings growth not too stable. Impending litigation (subpoena/tax credits) uncertain risk. Pulling out of business affected by subpoena: depressed earnings in subsequent years. Closely correlated to economic conditions; sells service more than unique product.
Conclusion: Fundamentally sound company, which would be a good buy if not for the litigation risk. That said, PE is near historic lows, so we recommend a moderate buy. That said, we might want to wait for (news of) a favorable litigation outcome.
Valuation model: DCF indicates share is relatively undervalued. All information from Yahoo! Finance (indicated by *) and Smartmoney.com Note: I could not find estimates beyond 2005, so I used 2003 results as year 0.
Current year (Year 0) EPS0, $ 1.57 Year 1 Consensus EPS Forecast (FY1), $ 2.04* Year 2 Consensus EPS Forecast (FY2), $ 2.11* Analyst consensus long-term growth (Ltg) 12.3% Plowback rate 0.66 Steady-state EPS Growth 4.0% Stead-state ROI (I set it equal to cost of equity) 7.7% Current Stock Price 29.88 Number of Shares Outstanding (billions) 0.09* Total Debt (billions of $) 0.18* Total Preferred Stock (billions of $) 0.00 Cash, Short-term Investments & non-operating assets (bill $) 2.11* Number of Transition Years 14* Computing Cost of Equity (re) Risk-free rate (yield on 30-year U.S. govt. bond) Raw Beta Adjusted Beta (1/3 + 2/3*raw beta) Risk premium on U.S. market (rm - rf) Cost of Equity (re) 4.98% 0.32 0.55 5.00% 7.71%
Value of Equity Per Share P/V Ratio
$42.53 0.70