Arthur J. Gallagher & Co. (AJG) Earnings Call Transcript & Summary

Good morning, and welcome to Arthur J. Gallagher & Co's call to discuss the acquisition of Willis Towers Watson's Treaty Reinsurance Brokerage Operations. [Operator Instructions] Today's call is being recorded. If you have any objections, you may disconnect at this time. Some of the comments made during this conference call, including answers given in response to questions, may constitute forward-looking statements within the meaning of the securities laws. These forward-looking statements are subject to risks and uncertainties that could cause actual results to differ materially. Please refer to the cautionary statements and risk factors contained in the company's press release regarding this transaction as well as the company's 10-K, 10-Q and 8-K filings for more details on its forward-looking statements and related risks and uncertainties. In addition, for reconciliations of the non-GAAP measures discussed on this call as well as other information regarding these measures, please refer to our most recent SEC filings and other materials in the Investor Relations section of the company's website. It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President and CEO of Arthur J. Gallagher & Co. Mr. Gallagher, you may begin.

Thank you. Good morning, everyone, and thank you for joining us this morning on such short notice. On the call with me today is Doug Howell, our Chief Financial Officer. During today's call, Doug and I will be referencing the presentation that is posted on our IR website, the PDF right below the link you click to join this call. We are elated to announce the acquisition of Willis Re's Treaty Reinsurance brokerage operations this morning. [indiscernible] Willis Reinsurance business on a previous call as a jewel, and it certainly is that. The operations are top-notch, complementary to our growth strategy and the people are just fantastic. Their leadership is excited to join our team and together with our thriving Gallagher Re operations, we will combine to create a world-class array of resources and capabilities. We're excited to welcome all of our new colleagues to the Gallagher family of professionals. You are -- would love being part of this culture. Let's go to the presentation. I'll start by giving you an overview of the transaction on Slide 4. In total, we're acquiring $740 million of pro forma revenue, $260 million of pro forma EBITDAC, and we are paying an initial gross consideration of $3.25 billion, a really fair price. Moving to Slide 5. Broadening our reinsurance brokerage offerings has been a long-term strategic objective for Gallagher. Combined with Gallagher Re, we will significantly increase our size and scale, but more importantly, enhance our global reinsurance brokerage value proposition through increasing our product breadth and service offerings, adding a wide range of analytic capabilities, further leveraging our industry-leading alternative risk in ILS businesses, strengthening relationships with our major insurance carriers, and we are adding a great management team that leads an organization with a strong sales-based culture, which is very similar to Gallagher. Moving to an overview of the treaty reinsurance business on Slide 6. The business has a client list of more than 750 insurance and reinsurance carriers. Operates in 24 countries and places more than $10 billion of annual premium. You'll see the treaty business is 45% North America, 40% U.K. and 15% around the rest of the world, notably Australia, Singapore, Japan, Germany, to name a few. And it's not just geographic reach that comes with the transaction. We'll add reinsurance expertise in areas like property catastrophe, agriculture, cyber, health care, A&H, reinsurance, capital markets, retrocessional et cetera, et cetera. Another exciting part of the team joining us are the 500-plus professionals focused on data and analytics ranging from actuarial and capital modeling to catastrophe risks and insurance-linked securities, to strategy and financial advisory, just a plethora of expertise across the franchise. Ultimately, we think combining Willis Re's Treaty brokerage operations with the best start-up I've seen in my career, Gallagher Re, should drive tremendous value for our clients, carrier partners and shareholders. So overall, an exciting transaction for Gallagher and our stakeholders. I'll stop there and turn it over to Doug to discuss the transaction terms and financials in more details. Doug?

Thanks, Pat, and thanks, everyone, for joining today, again, on short notice. This is an exciting acquisition, a leap forward for our long-term strategy. To vault into the top 3 reinsurance broker overnight is just fantastic. Today, I too will base most of my comments on the presentation that we posted on the website, and then we'll quickly turn to M&A. All right. Let's turn to Slide 4. As Pat mentioned earlier, the acquired operations pro forma revenues are $745 million with pro forma EBITDAC of $265 million. That $265 million contains only about $5 million to $10 million of synergies. This isn't an expense takeout deal. It is a very healthy business, already running at nearly 35% EBITDAC margin. So very profitable. The gross initial consideration is 12.3x EBITDAC or $3.25 billion. And when factoring in about $100 million of net assets and working capital, the effective multiple declines to about 11.9x. You'll also read that there is a 3-year earnout based on revenue growth. If the maximum earnout is reached over the 3-year period, our effective multiple would be closer to 10x. Once again, a very fair purchase multiple for such a high-quality business, yet still below our trading multiple, so it's immediately accretive. As we plan on financing the initial consideration using the cash we have here on hand, that does include the $1.4 billion of net cash raised from the follow-on common stock offering and the $850 million of 30-year debt, both of those raised in May. The balance will be from additional free cash on hand, plus free cash generated before close and, if necessary, short-term borrowings on our line of credit. So we don't see financing risk on this transaction. And importantly, this does not impair our ability to continue our proven tuck-in M&A growth strategy. This financing mix also allows us to maintain a prudent leverage ratio and maintain our commitment to solid investment-grade rating. We estimate these pro forma acquired operations are about 5% accretive to our 2020 adjusted GAAP earnings per share, excluding clean energy. If we also exclude the noncash amortization expense from the calculation, it improves to nearly 10% accretive. This is just really terrific. So let's leave Page 4. Pat touched on Pages 5 and 6. So let's flip back to Page 7. The pie charts tell an important story. While this is a strategically important addition to our scope of operation and adds a really nice diversification, it doesn't dramatically impact our geographic footprint. We are already operating in many of these countries, so we have on-the-ground experience there. You'll also see that when you look at the relative size of the pie charts, this acquisition adds about 12% more revenues, but it doesn't move the geographic or mix of business that much at all. And from an employee account perspective, the additional 2,200 colleagues that we note on Slide 6 is only another 6% compared to our more than 35,000 professionals today. So this is a very manageable transaction for us. So let's now move to Page 8. Given the business is highly homogenized and we're already in the reinsurance business operating on the IT system, we'll be using when we come together, the size, nature and scope of this business makes a really manageable integration plans. So again, I'll say it again, I don't see a significant integration risk on this. With this on Page 8, this top chart shows we're expecting to spend around $250 million in total over 3 years to integrate these operations. This consists primarily of 2 items: retention agreements; and two -- and the second item, cost to migrate the reinsurance business onto our Re platforms, in total is $250 million. As I said before, we're not assuming significant expense synergies in our estimates. But naturally, over time, as we consolidate real estate, migrate to common system and improve processes essentially Gallagherizing the back and middle office over the next couple of years, we should generate some savings that would help fund additional growth initiatives as we invest in the business. So moving to the bottom of Page 8, you'll see this business is highly seasonal. Please consider this as you build your models. Finally, in the presentation, Pages 9 to 11 are just reconciliations we provide to get you to the 2020 adjusted EPS before clean energy, and those are what we use as the base lines for our accretion calculations. Two other points before we go to Q&A. First, the closing of this transaction is dependent on regulatory approvals across multiple jurisdictions and other customary closing conditions, but we currently anticipate closing during the fourth quarter of 2021. Second, given today's announcement, we have pressed pause on our recently announced share repurchase program. So let me recap. This is an exciting and compelling acquisition. It accelerates our long-term strategy, adds talent and capabilities, is profitable and growing and is nicely accretive to our adjusted earnings. With that, I'll turn it over to the operator for questions.

[Operator Instructions] Our first question is coming from the line of Elyse Greenspan with Wells Fargo.

My first question is, are you buying exactly what you were going to buy in the prior transaction? I think the revenue was off by $5 billion, but I'm not sure if that's just additional breakage. Or what's actually being bought is maybe a little bit different than the prior transaction with Willis AR?

There's a couple of different things. Hong Kong and China have been added to the mix where they weren't in the mix last time. And second of all, there is lesser fac business that we're acquiring on this trend. The fact reinsurance business is staying with Willis.

And then if you -- In terms of revenue breakage, I know you mentioned that in both sets of transactions. Can you just give us a sense of the breakage that you're assuming, I guess, to kind of come to what seems like a conservative starting point of revenue?

Actually, this business, we haven't assumed much breakage that isn't already in the historical numbers. We think the teams are in pretty good shape, and they were growing through it, even with losing some teams. So we -- there isn't a significant amount of breakage in these numbers.

Okay. And then since from the capital perspective, it sounds like you're using, right, the equity and the debt and then cash on hand. I know in your last conference call, we kind of spoke about perhaps there being a good amount of deal flow of your normal transaction at the end of this year. So would the idea be if those deals materialize and perhaps, we see additional debt? Or how are you thinking about, if it ends up being a pretty strong entity year-on-year normal tuck-in M&A activity?

Well, I think that we still have plenty of firepower to complete the year strong. And then coming into next year, there's substantial cash flows that can be used that. I think over the next couple of years, there's easily well over $3.5 billion worth of M&A that we can do without significantly using any more stock.

Our next questions come from the line of Paul Newsome with Piper Sandler.

Congratulations on the deal.

Thanks, Paul.

I'm curious as to how this will affect, if at all, sort of strategically where you want to grow prospectively. You mentioned the fact business. I don't know if that's something you also want to build or if there are other parts of reinsurance that are now still open for your attention.

Well, yes, Paul. So Pat, first of all, yes, we are -- we will build out fact over time, and we do have considerable amount of fact presently in Gallagher Re. So this is not a new line to us, we just didn't take on their fact, which is really kind of directed fact off of the retail book. So that's an opportunity for us to continue to grow. This places us very nicely in the top tier of reinsurance brokers, and that opens up immense numbers of doors for us. It's one of the reasons we're so excited about it. It does enhance our capabilities, as we said in our prepared remarks, across a whole host of new areas. And the buyer's market is very interested in seeing this come together as a success. So I think it will be a great growth area for us, yes.

Does the -- does the piece have any -- I mean how does this piece fit with what you currently have? Is it any different structurally just adding on? Or is there a little bit of an integration with actually the current Gallagher Re business?

Well, we think it's going to fit like a glove. And of course, we spend a lot of time talking about that as we brought it together the first time around. Both teams are very excited because in every single instance where we're doing cyber and they're doing cyber, 1 plus 1 look like 5. And where we're doing excess of loss stop, they're doing -- the 2 teams rather than battling coming together on both sides, we're incredibly excited. So it's a very, very good fit.

Great. That's all I had. Congratulations on the deal.

Thanks, Paul.

Our next questions come from the line of Greg Peters with Raymond James.

So I want to go back to the concept of breakage or the teams departing, and I guess, where the base is for the earnout. Is the base for the earnout calculated based on the trailing 12-month revenue? Or is it -- because I think there's been some subsequent departures of teams within the last 12 months. And so just trying to understand where that base number is to calculate off of the -- for the earnout. Does that make sense?

Yes. I can answer that, Greg. Here's the answer. First of all, it's measured purely based on 2024 revenues, all right? So anything in the past is irrelevant. It's what do we do together in 2024. There's a mechanics that goes through this that gets us back to what the core Willis Re business would be. There's a multiple that's applied to that in 2024 that's paid in 2025. So any of the defections, any of the of the breakage that would have happened between now and then would be contemplated in the earnout calculation that happens in 3 years' time. Now let's talk about the magnitude of it. I think that if you listened to what Willis said in their earnings release a few weeks ago, this business is growing in the mid-single digits somewhere despite the breakage in that. So this is a business that is managing through the breakage. And I think right now, there's a lot of fired up people about being part of the Gallagher team that we believe that we can do really well on holding those folks in there throughout the closing process and become a part of our team. So we factored it in there. We've controlled for that in the earnout calculation. But most importantly, these folks are out there servicing their clients. And I think they're going to be excited about being out of a new home with Gallagher.

Yes. It certainly seems like there's some potential there for you guys. It's interesting, pivoting back you might have brought it up, what Willis said on their last conference call. And they also -- in part of their response around Willis Re, they also said that the margins in that business were excellent, but unlikely to go any further. So I guess I looked at your adjustments for integration, but what's your view on like the longer-term structural margin opportunity in the treaty business? Is 35% margin, can it go to 40%? Or is 35% going to go to 30%? Or just give us some perspective on that.

I think holding it where it is, is probably our objective. I think it's the reinvestment into it. This is a business that's been caught a little bit between the boat and the dock for the last 2 or 3 years. I think there's opportunity for us to continue to invest in its growth. So this is a growth story, not a margin story for us. And it's a sum of the parts story where, 1 plus 1 plus 1 can equal 5. And that's the story on this. I don't -- I think we're happy with where the margins are right now. I think there is room for investment that we'll make, if there's any synergies that we pull out of this. So don't think of this as a synergy story. It's a growth story.

Got it. I guess the final question, and this is more of a detailed question, Doug. But if I look at the overall footprint and structure of Arthur J. Gallagher, with this transaction, it seems like from a reporting standpoint, you might be in a position to reconsider how you're reporting your results as opposed to rolling up reinsurance just in the entire brokerage segment, if you're breaking out, giving us further color on brokerage. But I -- obviously, it's early days, but I'm wondering if you guys have any perspective on that in terms of what we consume from the outside.

Yes. Listen, I think we've done a pretty good job of breaking down our brokerage business in our conference calls to give you some flavor underneath. We'll look at that. I don't see this as being a catalyst for another segment in our reporting this brokerage and realize why you get to get allocations across segments. You get into accounting differences between segment. We want everybody pulling on the same set of oars. And right now, our Risk Management segment is a completely different business. But when it comes to broking insurance, whether it's for reinsurance, whether it's for direct riders, whether it's through wholesale, I think we'll give you a really good idea of what these businesses are doing, but perhaps not be on a GAAP segment basis.

Our next questions come from the line of David Motemaden with Evercore ISI.

I just had a question just on some of the cost adjustments that you guys made to normalize the operating expenses. Could you give us a sense of how large those cost adjustments were that you made? I'm just looking at Slide 8, some of the fine print that you guys spoke about.

All right. I can take a shot at that. If you pick up Willis Re stand-alone operations budget for 2021, it's $258 million. They're ahead of budget this year for that number. So when we talk about a number, that's $265 million, there's very little adjustment between what they're reporting in their own numbers and what we expect to report in our numbers. What would be things that would go, some puts and takes, probably a little bit more revenue is coming in than originally expected in their budget. Probably a little more T&E will come back in that -- those offset each other. And then there's some cost that we think that as we run some of these operations through our kind of centers of excellence and through that, there's very small incremental lift in that. So the answer to this is, there's not a lot of difference between what their budget is and what we're reporting in these numbers here.