Arthur J. Gallagher & Co. Q3 2013 Earnings Conference Call Transcript

The following is excerpted from the question-and-answer section of the transcript.

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : Thanks for taking my questions. Just a couple quick ones here. First, I wanted to ask about the margins on the exchange business, the partnership with Liaison. I guess there, I know you said they are both as both a commission and a fee component. Would that business have higher margins than the traditional benefits brokerage business, or would it be about the same? I just wanted to --

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : Okay, that's fair. And then the second quick question I just wanted to ask, just a numbers question -- that line you have, I think it was about $2.5 million disposed of operations. What is going in there, exactly? I just wanted to get more clarity into that.

Question: Gregory Locraft - Morgan Stanley - Analyst : I just wanted to ask on coal, it looks like in one of the notes or in the release that you guys acquired another five plants or something from a third-party on September 1. Can you give us some color what happened there?

Question: Gregory Locraft - Morgan Stanley - Analyst : Okay. But these are new plants. This isn't an existing investor that just wanted to walk from the investment that you had to bail out?

Question: Gregory Locraft - Morgan Stanley - Analyst : Got it. And do you anticipate more of these kinds of deals? In other words, are there developers out there that are basically doing what you all used to do and then bringing it forward to you because you guys have an appetite and can use the tax credits more efficiently than they can?

Question: Gregory Locraft - Morgan Stanley - Analyst : And then again, I know this is a very, very hard business to predict. But obviously the miss was largely in that line in this quarter relative to what you thought it was going to be a few months ago. I assume it's all just production schedules, right? You are trying to guess utilization at the utilities? Is that the entire reason?

Question: Gregory Locraft - Morgan Stanley - Analyst : Yes. No, I know it's a good thing for cash over time. It's just trying to predict it, which sounds like you are wrestling with as well, and it sounds like we just have a more conservative plan on the table going forward.

Question: Gregory Locraft - Morgan Stanley - Analyst : Okay, great. Other entirely different question is just on the integration costs, and this is just something I'm wrestling with, Doug, which is you guys have done some excellent deals, especially in the third quarter. We've got Giles coming in the fourth. There is a difference between your adjusted numbers and your reported numbers due to integration expense. It's now running all through 2014 and 2015. At what point, does this become a cost of doing business for A.J. Gallagher because you are acquiring businesses constantly? I mean should we really be stripping it out for our purposes and for compensation? I think you guys pay yourselves on EBITDAC adjusted on an adjusted basis.

Question: Gregory Locraft - Morgan Stanley - Analyst : Oh, you do. Okay. (multiple speakers) So the Board sees it as -- okay, great.

Question: Gregory Locraft - Morgan Stanley - Analyst : And again, it's perfectly disclosed, so we know what it is reported and adjusted. So that's good, and the deals are good. Last is just on Giles. Again, you guys are picking these up at good prices, but it sounds like you are very clear that you are going to use the credit facility, pay 1.3% to pull it in, it's an all-cash deal and then you are going to term it out. The terming out -- how do we think about the cost of debt or the cost of funding as we model our interest expense going forward?

Question: Gregory Locraft - Morgan Stanley - Analyst : Okay, good. That's helpful. Nice job in the quarter again, and I will let others to ask more about that. Thanks again.

Question: Sarah DeWitt - Barclays Capital - Analyst : Looking at the two big acquisitions you did with Giles and Bollinger, has there been a change in the acquisition strategy where you are going after bigger deals now, and then also what do you see as the overall accretion from those deals? Are there any risks to achieving that?

Question: Sarah DeWitt - Barclays Capital - Analyst : And then looking at your private exchange with Liaison, how many enrollees do you have there, and how big of a revenue opportunity do you see this over time? It is more just shifting your existing benefits clients from broker to an exchange, or is there an incremental revenue opportunity?

Question: Sarah DeWitt - Barclays Capital - Analyst : Should we view this as revenue neutral because you are just shifting existing benefits customers onto the exchange, or is there an incremental revenue opportunity there?

Question: Michael Nannizzi - Goldman Sachs - Analyst : Just to follow up on that, do you expect then that benefit companies will provide a bigger part or become a bigger piece of your M&A program, just given that you are competing with folks that just don't have the expertise that you do, and do you see opportunities in this part of the market?

Question: Michael Nannizzi - Goldman Sachs - Analyst : And then another comment you made on the rational rate setting, I don't know if you addressed this in front of -- I missed the first couple minutes. But where is that most relevant? Is that standard lines, specialty lines, large risks, small risks?

Question: Michael Nannizzi - Goldman Sachs - Analyst : And then just one on kind of still on that theme. If that's the case, do you expect that you could see more interest from insurance companies looking to build out areas in areas where they don't have infrastructure to see more interest in the services Gallagher Bassett provides?

Question: Michael Nannizzi - Goldman Sachs - Analyst : And have you seen new customers of size come in or approach Gallagher Bassett recently?

Question: Sean Dargan - Macquarie Research - Analyst : Just following up on the Risk Management business, I'm wondering if your 16% EBITDAC margin target still holds here. I now you called out several initiatives with Gallagher Bassett. But could you quantify the level of additional investment made this year and in the quarter from a dollar perspective?

Question: Sean Dargan - Macquarie Research - Analyst : Okay. And so the guidance still holds? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: Adam Klauber - William Blair & Company - Analyst : A couple different questions -- great acquisitions on Bollinger and Giles. Right now, are those businesses growing organically as much as the other businesses, or is that an opportunity to get them growing faster?

Question: Adam Klauber - William Blair & Company - Analyst : That's great. Another question. Talking about wholesale a little, has that growth been better than your average over the last couple quarters?

Question: Adam Klauber - William Blair & Company - Analyst : And how much of that business is property, and do you think that will be more impacted next year as property potentially is under more pressure than some of the other markets?

Question: Adam Klauber - William Blair & Company - Analyst : Okay. That's helpful. And then finally, any view on supplemental and contingents or at least what factors we should be thinking about as we go into next year?

Question: Adam Klauber - William Blair & Company - Analyst : Okay. Shouldn't you with new deals, Bollinger be included in a bunch of new deals, shouldn't that push it up somewhat?

Question: Josh Shanker - Deutsche Bank - Analyst : So obviously you are not the only one in healthcare exchanges; we are learning on the fly here. You talked about this revenue neutral opportunity for current clients. Can we talk a little bit about how you are paying your partner, Liaison, in that situation, what they are making LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies. out of it versus --? So is it more revenue than you would make ordinarily, but you are splitting that revenue with someone, or how should we think about that?

Question: Josh Shanker - Deutsche Bank - Analyst : And one thing I'm always very unclear about is, what service are you providing the clients in advising them, and what service is the actual exchange backbone providing them in that relationship?

Question: Josh Shanker - Deutsche Bank - Analyst : And those partners are paying you a commission?

Question: Josh Shanker - Deutsche Bank - Analyst : Well, I think that it's very clear, and I appreciate the learning curve is still, for many of us, being climbed. So thank you and good luck.

Question: Charles Sebaski - BMO Capital Markets - Analyst : I wanted to talk, one, about strategy, the Giles acquisition in the UK. Most of the ramp-up on the P&C business has been domestic. What are your thoughts about further growth in continental Europe or other international expansion?

Question: Charles Sebaski - BMO Capital Markets - Analyst : I maybe misstated the question. I think the Giles transaction is great. I'm talking about additional breadth of middle-market size business like Giles in continental Europe, for instance, like that kind of thought process, not questioning the Giles or how that fits in.

Question: Charles Sebaski - BMO Capital Markets - Analyst : One numbers question -- did you say earlier that the amortization expense is going to run around $34 million?

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : On the exchanges, when you shift from a group plan to the individuals shopping for insurance on the exchanges, what are you seeing on rates?

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : Yes, sure can. Whatever the per person per month fee might have been under the group plan, once those individuals get shifted over to the exchange, and presumably it's an individual product where there is more selection, can you talk about how many carriers are actually active in those exchanges, and what is your assessment of their pricing? What is the experience for the individual? Are they finding that pricing is better or worse when they go to the exchanges? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : Per the broader experience, when the individuals get their own in the individual market and pre-existing conditions have to be taken, it seems like the rate is more likely to go up.

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : So I guess you are describing sort of a hybrid where the group plan is still in effect, and the individual is protected from the market, so to speak. Initially when that goes to here's your subsidy, have at it, what is the risk of their sticker shock at that point?

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : And my final point is that worked because everyone knew in the group that both sick and healthy were going to be in the group. And so the carriers could underwrite based on that assumption. If you then throw it open and the sick people buy the coverage and the healthier people buy less coverage or no coverage and put the subsidy in their pocket, then they become --

Question: Mark Hughes - SunTrust Robinson Humphrey - Analyst : Completely separate question -- the international market, 10% growth as I understand it organic on the brokerage side. Is there some reason that was elevated this quarter, or is there some reason that should be sustained at a higher level going forward?

Question: Brian DiRubbio - Yield Capital Appreciation Partners - Analyst : I just have one question, and it was regarding the two big acquisitions. What was the motivation for both these guys to sell to you at this point in time? You've done now a couple of very large acquisitions. What's the change in motivation at Gallagher to do the larger acquisitions now where historically you have shied away from that? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: Brian DiRubbio - Yield Capital Appreciation Partners - Analyst : I think both deals are great. It was just to see two large deals done so close to each other was a little bit of a change.

Question: Brian DiRubbio - Yield Capital Appreciation Partners - Analyst : Great job, guys. Thank you.

Question: Dan Farrell - Sterne, Agee & Leach, Inc. - Analyst : Just another question for you on the clean energy. The ultimate annual after-tax earnings that you put in as the ultimate target is a good deal higher than where your guidance would be for 2014. Can you talk about some of the differences there in that? Those ultimate targets also don't include some of the ones that are in negotiations as well. So I'm just wondering -- explain the gap a little bit? Can you talk about overtime do you see the gap and what you are earning in those ultimate targets closing? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: Dan Farrell - Sterne, Agee & Leach, Inc. - Analyst : And then just another question on the two large deals that you've done. On a full-year basis, how do you think about the impact to overall margins to the segment? I think in some of the disclosures, it seemed like these were higher-margin businesses that might need a little investment, but still I'm just trying to think about how you think of the impact to the total margin?

Question: Dan Farrell - Sterne, Agee & Leach, Inc. - Analyst : Okay. All right. Thank you very much.

Question: John Campbell - Stephens Inc. - Analyst : It's John Campbell in for Brett Huff. Just trying to get a better sense for M&A just heading into 2014. I know it's tough to tell at this point, but it's been, I would say, a blistering pace over the you can call it three years. So just on a very high level view, do you guys anticipate running at that type of pace, or should we may be expect I would just say a meaningful slowdown, maybe back to that $100 million or so level we've seen in the past? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: John Campbell - Stephens Inc. - Analyst : Okay. Thanks for that color, Pat. And just one housekeeping item. I mean the brokerage tax rate -- it came in a little bit lower than we were expecting. But just given Heath and Giles and, Pat, I believe you said that the rate outside the US now is about 30%, but maybe just what your expectations are for the brokerage tax rate in 2014?

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : I had a follow-up on the exchanges. Specifically, I wanted to ask about the small business health options program. I know right now that's only available to smaller employers. But once that does open up, to what extent do you anticipate that that would pose at least some level of a competitive threat, or is that something that would be rather meaningless to your clients? LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : Okay. That's fair. And then just another follow-up. I know you had mentioned before that I think 85% of the competition was smaller brokers where it's basically an easy win for Gallagher.

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : I'm sorry, I guess easier win.

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : I apologize. My question is, with the remaining 15%, I guess my question there is, what is the value proposition that Gallagher offers that would allow new business wins in that market? What's the differentiating factor there?

Question: Arash Soleimani - Keefe, Bruyette & Woods - Analyst : Okay. That's fair. Thank you for the answers. LSEG STREETEVENTS | www.lseg.com | Contact Us consent of LSEG. 'LSEG' and the LSEG logo are registered trademarks of LSEG and its affiliated companies.