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Arthur J. Gallagher & Co. (NYSE:AJG)

Q4 2012 Earnings Call

January 30, 2013, 09:15 am ET

Executives

J. Patrick Gallagher, Jr. - Chairman, President & CEO

Doug Howell - CFO

Analysts

Mike Nannizzi - Goldman Sachs

Arash Soleimani - Stifel Nicolaus

Gregory Locraft - Morgan Stanley

Sarah DeWitt - Barclays

Mark Hughes - SunTrust

Adam Klauber - William Blair

Brian Durubio - Yield Capital

Bob Glasspiegel - Janney Montgomery Scott

Ray Iardella - Macquarie

Joshua Shanker - Deutsche Bank

Brett Huff - Stevens

Operator

Good morning and welcome to Arthur J. Gallagher & Company’s Fourth Quarter 2012 Earnings Conference Call. Participants have been placed on a listen-only mode. Your lines will be opened for questions following the presentation. 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 certain risks and uncertainties that will be discussed on this call and which are also described in the company’s reports filed with the SEC. 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 & Company. Mr. Gallagher, you may begin.

J. Patrick Gallagher, Jr.

Thank you, Christine. Good morning everyone and welcome to our fourth quarter and year-end earnings conference call. Today, I am joined by the division head’s that run our businesses as well as Doug Howell, Chief Financial Officer.

Before I get into my prepared remarks, I want to thank the sell-side that are listening in today; I think many of you probably seen the December ’12 and January ’13 issue of Institutional Investors and in that magazine the sell-side voted Doug Howell The Best CFO in the insurance business and I think that's well deserved.

Today, we are going to talk about the quarter and the year-end. Another record quarter and a record year and I will tell you it feels really, really great. Our team hit on all cylinders throughout all 2012. Our growth came from all operations across all geographies. I couldn’t be proud of the team and our results. We are growing the company for our shareholders, year in and year out, quarter after quarter. We are getting stronger in our capabilities to deliver services to our clients and to attract new business.

In the fourth quarter, we did 21 acquisitions bringing in $76 million of projected revenue. Our legal teams, our HR teams, all the support groups’ seamless efforts to put these people on the books, incredible, incredible work. The fourth quarter was also a testament to our sales culture and the strategy we’re focused on for years.

Everyday, we focus on four things, I’ve mentioned on this call many times. The first is organic growth. Everyone in this company knows that nothing happens until somebody rings the cash register. The second thing we are after is mergers and acquisitions and attracting the best entrepreneurial talent in the marketplace to our growing family. Third is productivity and quality. We are always looking to do a better job for our clients and to improve our margins along the way. And fourth, we work hard everyday at maintaining our unique team oriented Gallagher culture.

Thinking about these four things everyday has served us well and those are the four things we are going to stay focused on as we go into 2013 and beyond. When you look at our Brokerage segment and Risk Management segments together, adjusted revenue was up 14% in the quarter, 15% for all 2012; adjusted EBITDAC was up 17% for the quarter and 20% for the full year and margins expanded in the quarter and for the full year.

All-in-all an excellent quarter, another record year for Gallagher; our production force is winning; we’ve turned on and really providing great results. The fourth quarter is our eight quarter in a row that we have posted positive organic growth. So many of the things that succeeded for us in 2012, we believe will carry over into 2013 and continue to prove successful for us again.

In 2012, we completed 60 acquisitions bringing in annualized projected new revenues of $232 million. We project that $130 million of that will hit our books in 2013. This is again across all divisions, across all geographies and our pipelines still remains strong. These firms added greatly to the niche expertise we talk often about and to our geographic footprint. They brought us a couple of hundred new producers, who now are armed with our capabilities and who we expect will produce significant new business in 2013. Think about it.

We give the production force greater opportunities to grow their book of business and to make more money. Our Risk Management segment, Gallagher Bassett for 2012 had revenue growth of 7%, adjusted EBITDAC was up 11%, organic growth and base domestic and international fees for the quarter was 2.9%, but importantly, the way we handle our clients is recognized. Gallagher Bassett was recognized by business insurance readers as the top TPA for both small and medium sized companies and this is the fifth consecutive year we've been recognized by the readers of business insurance.

Again, the sales culture is strong. New business was excellent throughout 2012, and was especially strong in the fourth quarter. In addition, we continue to have strong business retention. Our account retention across both segments is nicely in the mid-90s. Our sales teams are doing a fantastic job of explaining the value proposition that Gallagher has to offer through the entire insurance spectrum.

Let me move to a number of individual operations and I will start with the Brokerage segment. In property casualty retail, we continue to see rates increasing; it feels as we start 2013 very similar to what we felt in 2012. Most lines are experiencing mid single-digit increases, catastrophe exposed property especially in the Northeast looks like it’s going to be up a little more than that and workers compensation could be a bit higher across the country as well. We are not experiencing a traditional hard market, but rates are moving up consistently across all lines and as I mentioned, workers comp is aligned in many states that’s in distress and we are seeing increases excess of 10% most of the time in that line.

Again, this is not a balance sheet driven correction; these are income statement driven connections, carriers realize they are getting no investment income and loss cost are continuing to rise. With costs inflating, a flat renewal is actually a step backwards for the carrier. The senior managers at the insurance companies we trade most with remain resolute that their team has got to get them increases. We have not seen the discipline abate during the quarter. So by and large, rates are continuing in positive territory.

I want to emphasize that I believe steady increases handled overtime are much better for our clients than a dramatic change; adjusting the low single-digit increases after virtually eight years of rate decreases is much more manageable for clients; nobody wins when rates jump 50% to 100% and insurance is difficult to buy. And also, remember, you have to recognize that rates are now still at levels we saw in 1999 which was before the last really hard market.

As it relates to the economy, I believe that fiscal cliff and lack of clarity around taxes negatively impacted our clients businesses especially in the second half of 2012, but as we come into 2013 and there is more clarity around what’s going to happen in that regard, we believe our clients businesses are showing a little bit of improvement because we are seeing this in some positive audits. If we can see a continuation of positive rates and a little improvement in the economy, we believe we’ve got really good momentum going into 2013.

Let me touch on our International Brokerage; we had a very strong quarter and a very strong 2012. The acquisition year ago of Heath Lambert has given us a great platform to bring a whole new opportunity to our merger and acquisition efforts. Our pipeline continues to be strong. We completed seven acquisitions internationally, four in the UK, one in Australia, one in the Caribbean and we purchased 21.3% of Grupo CP in Mexico which cements what was already an excellent relationship going back well over a decade, with the Casanueva family in Mexico City and it opens up great new opportunities for us in Central and Latin America.

Our Wholesale and MGA business had a strong finish to the year; new business was strong, our hit ratios improved; on submissions, our submission growth was solid. We saw a continued organic growth in the business which we feel really good about. Our business is moving back to the excess and surplus markets and we have a team of professionals that know these markets inside and out. On the MGA side, according to business insurance, we’re the largest firm. We saw an improvement in new business startups which also helped this growth organically.

Let me move to our benefits business and now I want to spend a little time here. The benefits business is in a really, really good position. I think we are positioned to do extremely well on behalf of our clients in what is a real changing environment. Our benefits operation did 33 acquisitions in 2012, and I think this is another example of our efforts to be prepared for the new healthcare law; those efforts really paying off. These new firms will bring in projected annualized revenue of $82 million.

Now, what this is showing me again, and I have mentioned this to many of you, I believe that independent benefits brokers need much stronger consulting expertise in order to deal with the changing environment. I expect pressure to continue to build in that regard because as we get closer to 2014 many of the laws provisions go into effect.

So during 2012 we also announced the formation of a private exchange in partnership with liaison. We can now help our clients whether they prefer to continue with a defined benefit approach or defined contribution approach. Still too many clients are sitting on the sideline thinking that they are just going to maintain what they've got and deal with the law down the road sometime.

I had a long conversation with a sizeable client just last evening and I couldn’t get them off the dime as it relates to being prepared for 2014. I think that's going to create a tremendous opportunity for us. In the near-term and long-term we have built the expertise to be able to deal with this changing environment.

So I'll go back to our total M&A efforts this past year. 60 acquisitions, $232 million of new projected annualized revenue, our pipeline is strong and clearly a key part of our growth strategy is to see to attract strong entrepreneurs in our firm and to give them additional capabilities to grow.

As I do every quarter, I want to stop and just thank those who joined us. I know you had choices and we are very, very glad you chose us. Welcome to our expanding family and I know you will contribute substantially in 2013 and beyond.

Let me move now to our risk management segment. Another solid quarter, another great year, we've now completed our wind down of the New Zealand earthquake activity and we've ramped up our operation in South Australia.

Think about this, in two to three months we hired a 185 people. We got them situated, trained and ready to pay claims in two to three months, unbelievable work by the team. Our international operations contributed greatly in 2012 and they will even do a greater amount of contribution in 2013 especially with the addition of South Australia.

We've invested over the past year a new IT tools that we refer to as the analytical work bench. It is continue to be well received by our clients and we are continuing to invest in client based products and services which should keep us in a really strong position both for renewals and for developing new business.

And even with ongoing investments in our service offering, we maintained our target margins of 16%. I continue to be very excited about the power the company is building to help our clients in this really risky world.

Our culture as I mentioned before is strong and I can't emphasize this enough. We are client focused, team oriented, upbeat and winning. All of us are involved in selling and servicing our clients and we firmly believe as an enterprise we are just getting started.

Over to you Doug.

Doug Howell

Thanks Pat and good morning everyone. Let's jump in and start on the second page of the earnings release with the brokerage segment. The first item you are used to seeing is the Heath Lambert integration cost. The (inaudible) size and we are on track to wrap up the integration in mid 2013.

So you will see just a couple of pennies of integration costs in the first and second quarter and then about $0.03 in the third quarter. The third quarter actually reflects the cost to consolidate almost all of our London operations into new space near Lloyd’s which will be the capstone on nearly two years of hard work by the team to put these organizations together.

The next item is a $0.05 charge relating to contracting our middle and back office. We took these actions at a time of strength because it was the proactive step to realize savings from our process improvement initiatives, increased utilization of our operational service centers and our investments in improving technologies. It’s also a prudent step to offset the impact of medical cost inflation to reduce the financial impact of our frozen pension plan and most importantly, allow us to continue to recognize and reward the broader work force.

And the third item in the brokerage segment is we resolved some tax items in the fourth quarter that cost us a couple cents. Recall that we resolved some tax items in the second quarter that generated $0.02 of earnings. So while it creates some noise between quarters, for the year they offset and have no impact on our annual numbers.

Moving slightly down to risk management, I’ve already hit on the severance cost item and the next item is the ramp up efforts to onboard our new clients in Australia that Pat discussed and as a reminder, that client should generate about $20 million of annual revenues here in 2013.

Let’s move on to page three. The brokerage segment had a terrific organic growth quarter, up 5.2%. That’s excellent work by our production folks especially given they were also up nearly 5% in the fourth quarter of 2011.

Looking across our units, each of them posted excellent growth. We saw about 5% organic in our domestic P&C operations, a touch over 5% in our domestic benefits units and a little over 6% internationally, so strong work across the table.

Turning next to the top of page four to the brokerage segment margin table. We're really pleased to continue to pose margin expansion here in the fourth quarter. Looking on an annual basis, for margins to be up 70 basis points on 4% organic growth is really, really good work by the team and more importantly, because we took the proactive steps to offset work force related benefit and compensation inflation, we're well positioned to control our compensation cost coming into 2013.

Next, while we don’t normally spend time in these calls on the non-EBITDAC items, let me pause for a second and give you some thoughts related to modeling depreciation, amortization and change in acquisition earn outs in 2013.

For depreciation, assume about $8 million of expense per quarter, for amortization assume about $27 million of expense per quarter plus you will need to make a [gap] for amortization from new M&A activity that arises in 2013.

And finally, for change in acquisition earn outs assume about $3 million of expense per quarter and that will cover the amortization of the discounted earn out payables. Also as my annual reminder, please use our investor supplement that we post on the website to build your models.

The adjusted pages removed is difficult to compare items which is helpful when you search your baselines, it also highlights how seasonally small we are in the first quarter which like I said last year has become even more pronounced because Heath Lambert is also seasonally smallest in the first quarter.

Okay, move down on page four to the risk management organic table. The temporary revenues related to the New Zealand earthquake claims are all but gone and without those we posted nearly 3% organic. This is down a bit from previous quarter and we believe that as an anomaly for two reasons.

First, we eased back a bit on new business in Australia as a team ramped up for the new $20 million account and we did lose a decent account which unfortunately happens from time-to-time in a competitive business but we believe that’s an anomaly.

That said, looking to post 5.7% organic for the full-year is really good work in an economy that isn’t seen much employment growth. As we look towards 2013, we have seen an organic growth environment similar to what we saw in 2012 plus we'll add about $5 million per quarter of revenues from our new Australian client.

Moving to the middle of page five, the risk management margins. We call last year at this time, the team set out to push its adjusted EBITDAC margins up about 50 basis points to 16% and also cover about a 4 margin point of cost to development some exciting client centric tools and resources, and you can see that they delivered. It was great work by the team.

This investing will continue in 2013, with productivity gains, we are still targeting 16 points of margin. All right, let's move to the bottom of page five to the shortcut table for our corporate segment.

For the fourth quarter, we posted a loss of $0.05 which was right in line with our $0.04 to $0.07 loss that we forecasted in our third quarter call.

For the year, we came in at $0.03 versus a loss of $0.26 in 2011; virtually all of that improvement came from clean energy investment earnings. As for 2013, rather than rattling through a lot of numbers on this call, we have expanded page 14 of our investment supplement on the website to include our current best guess range for each of this corporate segment line items.

The punch line from that schedule is that the corporate segment should post between $0.17 and $0.34 of earnings in 2013 plus $0.03 of loss here in ‘12. Page 14 also shows quarterly ranges because is pronounced seasonality in our clean energy investment earnings, so please use that page when building your quarterly models.

As a last part in clean energy investments, it’s important to remember that it was only 13 months ago that the team built in placing this service 15 new plants. Now when you read page six of the earnings release, you will see that we are only left with the few uncommitted plans.

Then when you look at page 14 of the supplement, you will see that we could make between $75 million and $90 million in 2013 from these investments, and that we continue to have success in ramping up the other plans that could bode well for even better earnings in 2014. The important takeaway on all this is that these investments could generate substantial cash flows which we would use to continue to fund our M&A program. That leads me to my wrap up commentary on capital management and funding our M&A growth.

In our last earnings call I said we had not used much stock to do M&A in the fourth quarter and we did not. As we look towards 2013, we intend to again favor cash and more debt to fund our M&A activity and avoid using stock. We currently have about $160 million of cash in the bank and we are also working on another $200 million of 10 year notes. All that said, if M&A activity exceeds last year and realize from time to time we must use stock and tax for exchanges then we might need to use some shares. But we are currently favoring cash and debt. So those are my comments. It’s been a really exciting year, but its time to put 2012 on the shelf and focus on delivering some excellent results here again in 2013.

Okay back to you Pat.

J. Patrick Gallagher, Jr.

Thank you Doug and Christine we are ready for questions, hopefully some answers.

Question-and-Answer Session

Operator

(Operator Instructions) Our first question is coming from the line of Mike Nannizzi with Goldman Sachs.

Mike Nannizzi - Goldman Sachs

I have one question on the charge, just trying to understand kind of what came first, was it the expectation that you would have that kind of $35 million expense or was it the expectation that you would incur these work force savings. Just trying to understand, have a thought process around the determination of that number, thanks.

Doug Howell

Good, just to clarify, we take $12 million of severance in related costs of charges and we expect to save about $35 million of which much of that will be offset by what we refer to as just work force inflation. Those were planned reductions based on our work in August and September to look at our staffing levels in light of the ramp up of our offshore centers of excellence and looking at our technologies and looking at our productivity gains. So it was a necessary step in order to harvest the savings that we expect as a result of the investments and just getting better at what we do everyday.

Mike Nannizzi - Goldman Sachs

I mean but if we were to peel that out, just peel that piece out for a second, the second part which is the increased medical costs, reduced discount rate on the pension plan, salary increases, performance based compensation, long term incentive, did you know, is that new or was that the result of the study or was that something that you kind of expected that you would be incurring anyway down the road.

Doug Howell

Those costs are always in place. Medical cost is going up. I think the decline in pension yields has been there and we've known about that and giving raises to and incentive comp to our broader work force, it’s something that is in our numbers every year. So this is something we just took, we saw it, but there was no surprise there at all.

Operator

Our next question is coming from the line of Arash Soleimani with Stifel Nicolaus.

Arash Soleimani - Stifel Nicolaus

I just wanted to clarify on Doug’s comment on the M&A financing. Would it be fair to assume that it would be roughly 75% cash and then 25% stock, is that kind of a fair breakdown?

Doug Howell

No, we intend to use 100% cash and debt to fund our M&A program unless for some reason in the structure of a deal, we need to use stock in order for tax to be at tax rate exchange, and if we have a merger partner that has a strong, strong desire to hold stock, we would consider give it in the stock in that transaction. But by and large, we are going to favor cash and debt.

Arash Soleimani – Stifel Nicolaus

That’s should continue in to 2014 also that logic?

Doug Howell

Yes, it should. But again if our acquisition appetite grows, we would have to use stock in the deal. We're trying to keep our debt somewhere south of two times debt-to-EBITDA. So at some point, if we really have a strong M&A pipeline, we would be back to using stock towards the end of the year.

Arash Soleimani – Stifel Nicolaus

My other question, in terms of monetizing (inaudible) is there any update in terms of timing of that or?

J. Patrick Gallagher, Jr.

We had talked about that last year, trying to be ready by the end of ‘12 on that. We think its port more of a mid-2013 exercise at this point.

Arash Soleimani – Stifel Nicolaus

Okay, and then lastly, in terms of the health exchange, I know you have the partnership with Liaison. Are you guys also looking to form other partnerships with other exchange platforms or do you think that’s going to be the primary partner over the next 12 to 24 months?

Doug Howell

We are entertaining partnerships with other providers as well.

Operator

Our next question is coming from the line of Gregory Locraft with Morgan Stanley. Please state your question.

Gregory Locraft - Morgan Stanley

Just wanted to pursue - the core operations look great, just on the coal side a very helpful chart in the supplement where you give forward guidance. Can you just go backwards though and talk a bit about what the guidance was versus what the actual came in at for clean energy and why the differences?

Doug Howell

Fourth quarter guidance we guided $0.04 to $0.07 of loss for a corporate segment. The clean energy production in the fourth quarter wasn’t quite as high as I had probably guided generally due to warmer weather in a couple of locations where we have plants. So compared to the fourth quarter we are little short on that but still not too bad.

Gregory Locraft - Morgan Stanley

Okay, so what you really want us Doug to do is to focus on the corporate segment guidance all in, not in the component parts as much, because obviously we keep cutting finally the numbers and there is going to be puts and takes. What I am trying to understand is just 75 to 91 on clean energy, how baked in the cake is that? What’s the difference between 75, what’s the difference between 91?

Doug Howell

I understand your question, we are highly dependent on the activities of the utility to dictate how much they actually burden of refined fuel or clean coal. So we sit down and we go through each of our utility partners and we get their best guess with respect to production for the next year, and we do suffer from weather issues, from plant maintenance issues. So I would say that our $70 million to $90 million is our best guess at this point, based on what we know now, and so I think it’s a range that we feel reasonably comfortable with.

Gregory Locraft - Morgan Stanley

Okay, and then any of this contracts that you talk about in the release spread could come through mid-year, is that all upside?

Doug Howell

We are taking our best guess with respect to ramp up of all the plans that we disclose in page 6, but it does not include any of our best guess for the plans that have not been put into the construction phase at this point.

Gregory Locraft - Morgan Stanley

Okay, perfect great. And then jumping into the M&A side just an awesome year, as you mentioned, it seems like people are choosing you with the destination. So I guess what I am trying to do is just model it, and I think you have been very upfront in saying take off free cash flow, do we then add an additional amount due to the clean energy funding so say $75 million bucks on top of free cash and then that becomes affectively the budget for M&A in 2013 and forward?

Doug Howell

Yes.

Gregory Locraft - Morgan Stanley

Perfect, okay, any incremental debt you would add, because you just mentioned less then two times and you could squeeze some in there.

Doug Howell

In my comments I said we are right now looking at adding $200 million.

Gregory Locraft - Morgan Stanley

Okay, I missed that.

Doug Howell

So we got a $160 million in the balance sheet, we got free cash flows that will develop this year plus $200 million of debt, so we have a lot of money to spend on acquisition this year.

Gregory Locraft - Morgan Stanley

Great, and then what's the rough revenue range at which you buy these things at, or how should we think about backing into, what if it can get in the market?

Doug Howell

Our multiples of EBITDA have been between 6 and 8 times historically.

Gregory Locraft - Morgan Stanley

Okay, perfect.

Doug Howell

We don't buy on revenue, we buy on EBITDA.

Gregory Locraft - Morgan Stanley

Yeah, of course, okay. Okay, that's great. And then the last one from me is the organic is sort of above that 3% threshold, where I think you guys have said at least in the past I think you got margin expansion above that level. So it seems like we should continue to, you know, we are running at a good clip there and no break in trends, so should we just expect kind of what we've been seeing going forward on the brokerage side?

Doug Howell

Well, we feel like the environment this year is a lot like last year at this time. When it comes to margin I've always said that if you expand, don't expect much margin expansion greater than, unless we have organic greater than 3% on the brokerage side and 5% on the risk management, but what the proactive steps we've taken to control our compensation and benefit, the natural inflation in that we feel good about our prospects for holding and then expanding margin in 2013.

Gregory Locraft - Morgan Stanley

Okay, great. I'll squeeze one last one just for Pat then, just your view on the cycle, you mentioned quite bullish comments on pricing and where it’s heading. Do you see an acceleration in the rate of change or do you think we are more in a unique world where we’re in call it 5% to 10% depending on the line for the next few years

J. Patrick Gallagher, Jr.

I think we are in a unique situation. This is my fourth cycle and it’s completely different than anything I have ever seen before. I do think it’s in that 5% to 8% continual pressure to push rates up.

Gregory Locraft - Morgan Stanley

Okay, multi-year?

J. Patrick Gallagher, Jr.

Well, we are going into the third one right now.

Operator

Our next question is coming from Sarah DeWitt of Barclays. Pleas state your question.

Sarah DeWitt - Barclays

I was wondering if you could elaborate on what drove the acceleration in brokerage organic growth versus the third quarter and maybe if you could break that down between what you are seeing in terms of rate versus exposure versus new to lost business that would be really helpful?

J. Patrick Gallagher, Jr.

I'll give you a general comment and let Doug comment on the break out if he can. But, we just had a great fourth quarter in new business and retention. I mean frankly coming into the fourth quarter and December in particular you know what your pipeline looks like and you don't know what your orders are going to look like. It’s an aggravating quarter and an aggravating month for me to be perfectly honest, because you can get hurt by one big loss, you can really be helped by various operations doing well and this is just as time we are in the fourth quarter and in December in particular across every geography, so our international operations had an incredible quarter, our MGAs and wholesalers strong organic growth, I already commented on our benefits operation and our straight PC retail folks knocked it out of the park in the quarter and it really comes down to incrementally keeping a better rate of retention and adding more new business. And in Doug’s comments this is the thing that I'm really proud of, it was a tough quarter to compare. Last year, if you recall in the fourth quarter, we also did 5% organic and didn't see that level of organic growth again for the three next quarters and to have a big quarter last year and then to do it again this year is just solid work by the team.

Doug Howell

Yeah, I think that Pat hit it; I mean basically we didn't get a lot of lift this quarter from economy and we didn't get a lot of lift from rate, it was just a little better new business and a little less loss business. So that's what we are seeing.

J. Patrick Gallagher, Jr.

The rate increases that we talked about by the way, I should comment on this, the rate increases that we are talking about by a comp by comp, we are working very hard to offset those for our clients. So we are seeing about 1% impact on our revenues from rate, so don't be thinking that just because the carriers are getting an 8% rate increase that necessarily our clients are paying that, they will take higher deductibles, they will move to self insurance; if it's really in a situation where they are squeezed economically, they will reduce coverage and overall impact in our numbers is just 1% from rate.

Sarah DeWitt - Barclays

Great, that’s helpful. And then on risk management business, can you just talk about where you are seeing in terms of clean trends there and based on your comment, is it right to think about the right run rate for organic growth around the 6% range in that business?

J. Patrick Gallagher, Jr.

Well, we thought the lower run rate for organic in the fourth quarter was an anomaly, and frankly, we did have some impact there, negative impact from a bit of a slower economy. So yes, I would think that our more normalized run rate would be something along the lines of 5% to 6%.

Sarah DeWitt - Barclays

Okay. And finally if I could just squeeze one more in, on the Australia business; is that business running around the 16% margin as well or something different?

J. Patrick Gallagher, Jr.

Yeah, about 16.

Operator

Our next question is coming from Mark Hughes of SunTrust. Please state your question.

Mark Hughes - SunTrust

Pat, did you say how the workers comp claims were looking within risk management?

J. Patrick Gallagher, Jr.

Did I say how they are looking?

Mark Hughes - SunTrust

Yeah.

J. Patrick Gallagher, Jr.

We didn’t mentioned it, but I can tell you we're not seeing claim count growth, because we're not seeing employment growth and what we are seeing is the same thing that the insurance carriers are finding is that we're seeing medical inflation within the comp line to a point where the medical costs are growing much faster than the indemnity costs.

Mark Hughes - SunTrust

Right. How about the, you had mentioned, I think the new business startups were looking better. Could you elaborate on that a little bit?

J. Patrick Gallagher, Jr.

Yeah, especially in our MGA book business market, that’s very sensitive to that. So when the economy tanked in ‘09 and ‘10 and really for that business to do well we need bars and taverns and tattoo parlors and people like that to start businesses and when they do, they end up in the excess and surplus market and then specialty programs and so we are seeing -- we have over the last really three quarters seen some improvement in business startup which is helping us in our MGAs.

Mark Hughes - SunTrust

Yeah, and the final question just touching on the margin issue again, Doug kind of the 5% organic but 40 basis points margin in brokerage. Should we expect a bit more than that if you are able to hold it kind of organic growth or is that an appropriate number?

Doug Howell

No, I think there is behind the 40 basis points expansion of margin this quarter there is a couple of subtleties that I think you should think about. First is, margins would have expanded probably another 20 basis points, but our 2012 tranche acquisition of M&A partners happened to be seasonally smaller in the fourth quarter just like Heath Lambert is smaller in the first quarter, this tranche of acquisitions tends to have smaller margins in the fourth quarter.

We also spent about another 25 basis points on more travel this quarter; half of that was related to the M&A activity, so may be 12 basis points of expansion; about six basis points were related to our efforts to harvest the productivity improvements that we have talked about that led to our workforce contraction and then may be another six basis points related just more to organic travel to get out there and see our clients and pick up new business.

So I am not saying that those are one-timers, but they did have an impact on margin expansion in the quarter that would not have the seasonality and maybe just little less M&A activity, probably would have expanded another 20 to 40 basis points.

Mark Hughes - SunTrust

I know you can count on that level of detail from the award winning CFO.

J. Patrick Gallagher, Jr.

There you go Mark.

Mark Hughes - SunTrust

Again, I’ll intrude by asking one more, how do those things look when we look at 1Q, the seasonality, the travel, productivity issues etcetera, are they is the impact similar kind of the slightly diluted in 1Q, or should it be more positive in 1Q?

Doug Howell

I think that the organic travel for new business and for our new business and our existing clients will be there in the first quarter, but that is only six basis points of costs. I think there is always a natural slowdown in M&A activity in the first quarter; there is, generally if you look at M&A activities and you do 60 deals, you know the first quarter people are kind of just catching their breath and then they target to get stuff down before the end of the year. So we always say we do a year worth of acquisitions in nine months, so that should be not be there the next quarter.

Operator

Our next question is coming from Adam Klauber of William Blair. Please state your question.

Adam Klauber - William Blair

Contingents on supplementals were up pretty good in 2012, how much of that is maybe having new carriers come into program or how much of that is just normal growth and what do you expect for 2013?

J. Patrick Gallagher, Jr.

I’ll touch on where it’s coming from and let Doug touch on what is sort of forecasting for next year. This is more about having new partners through the merger and acquisition process than it is new carriers coming in. Most of our supplementals and contingents are coming from the same partners that we worked with in building those programs over the last four or five years and its building more volume with the carriers that support us essentially with those revenues.

Doug Howell

Yeah, to contributing to that Adam is that we spent a lot of time on carrier analysis and compensation analysis and that's starting to pay some benefits there. As we look into 2013 frankly, the teams are hard at working with the carriers right now to come up with fair supplemental and contingent commission agreement. So I really won't have a big deal of that until the April call.

Overall, if you model that equal to what we did this year, you wouldn't be too terribly far off and then also we are starting to see a few carriers start talking about moving back from supplemental into contingents. That would create a timing issue perhaps that we normally accrued during the year but we might get it next March. So, I will give you more guidance on that in April on our call.

Adam Klauber - William Blair

In the benefit business, there's been pressure on commissions for smaller businesses, 50 lives in west even 100 lives in west; is there any movement by the health insurers to push that up past that 100 to 50 lives?

J. Patrick Gallagher, Jr.

You know Adam for us its really, that's kind of a non-event to be honest. We don't do an awful lot of business in the under 100 life case area. What we do is primarily above that level and when you get over a 100 lives whether even if the client chooses to pay it by commission, it’s a disclosed, negotiated discussed fee and so it comes through our books as commission but its really what the client agrees and we have for a decade now made it very clear to clients that in essence under risk for 20 plus years we've been transparent with our clients. If we have a certain level of cost, we need to cover that to do the work for the client. We are very transparent about that, we are very open and so the pressure on insurance companies to reduce commissions is not really impacting our benefits book-of-business at all.

Adam Klauber - William Blair

Can you give some idea what was organic in the benefits business this year in 2012?

Doug Howell

It is almost the same as what it was for the whole company.

Adam Klauber - William Blair

Okay, so pretty solid year and also in that same vein, how is organic in the London operations and Heath?

Doug Howell

It’s good. I think that I'm actually pretty pleased with that. The revenue retention there, I think that we are culling out some of that book-of-business as we look at it to say if we can't make money we will put it out. They are doing a good job of holding in there and we picked up some nice accounts over there too. I think that…

J. Patrick Gallagher, Jr.

We picked up some very nice risk management accounts with their risk management team and the team that we had in London before the acquisition. We've done an excellent job of holding on to books of business in both the affinity which is small business programs that we have as well as middle market and in the branches around the UK.

And as I said, we bolted on [four] acquisitions that we never would have been able to do if we hadn't done the deal so all in all organic growth is strong there and M&A growth is strong there and the team has done a really good job of integrating that business.

Just as an example how difficult that is, you can imagine Heath Lambert’s benefits programs were substantially different than our Arthur J. Gallagher’s benefits programs. Harmonizing those is really, really difficult and our team did a fantastic job of working through that so that we are all now one company, one set of benefits across the entire platform. That's just one example of the work that had to be done.

Adam Klauber - William Blair

Great and one last question what was the end of period shares if you haven't said that?

Doug Howell

Let's see, let me pull it out here its 425,600,000.

Operator

Our next question is coming from Brian Durubio of Yield Capital. Please state your question.

Brian Durubio - Yield Capital

Pat, a question for you, maybe, if Scott since there maybe he can answer it. If I heard you correctly a few moments ago, you said, you didn’t see much in terms of claim count growth in Gallagher Bassett. Is that correct?

J. Patrick Gallagher, Jr.

Organic claim count growth. Yes.

Brian Durubio - Yield Capital

So how should we think about employment growth, the [ADP] numbers were pretty good this morning. How that translates in to potential claim account growth? Is there any correlation that we can look to?

J. Patrick Gallagher, Jr.

It is very correlated. Gallagher Bassett is incredibly sensitive to the economy. When you are working three shifts and you take that down to one shift, you are going to lose two-thirds of your claim count. [Scott], go ahead.

Unidentified Company Representative

Yeah, we look at two things. I mean there is the overall claim count growth which is influenced by the new business that we bring on and then we also breakout kind of existing claim count growth and that’s the part that we kind of correlate to the economy specifically and that part of it is, we are talking about 5% to 6% claim count growth overall. The part that it is influenced by the economic growth that existing clients are about 1% to 2%, it is still relatively low and so until we see an uptick in the economic activity that part of it won't go much above that.

J. Patrick Gallagher, Jr.

I would also comment, Brian. We're not seeing FTE hires in our benefits book either. Our clients are not hiring people. Their businesses are getting a little better but they are not stepping up and hiring people.

Brian Durubio - Yield Capital

Okay, next question then, it's probably (inaudible) by Pat, yourself and Doug. So, inflation, there are signs of inflations moving up higher, you are seeing it in the yields of 10-year treasuries most notably. So I guess the two part question Pat for you how do you see that affecting pricing in the business in general and for you Doug I know you talked about raising $200 million in debt this year, but with your six and a quarter percent notes do in about [80 months] from now, would it make more sense for you to lever up a little bit more so you are locking them a lower rate for a longer period of time for when that bond matures in 80 months?

J. Patrick Gallagher, Jr.

Let me take the first half of your question Brad and then Doug can talk about the capital management secondly. I am really impressed within this cycle and I think this is both information situation as well as just strong management.

Senior management at the insurance companies know where they are making money, they know by line, by city, by country, by state they really have information at their finger tips. As I have said before, this is one of the first times in my career where what I am hearing from the senior executives at insurance companies is actually happening exactly as they are saying it on the street.

There is usually a bit of a disconnect as you are getting towards the end of a cycle and they know exactly what’s happening to their cost structure and if costs are inflating which (inaudible) is in fact inflating and medical is in fact inflating, they recognize loss cost are going up and they know exactly what percent that is and what the impact will be on the next year and they are going to try to cover that loss cost with rate increases and it’s actually quite impressive, they are doing a very, very good job.

And I think our people are getting better and better at explaining that to clients because when it first came about three, four quarters ago may be six quarters ago frankly, all the people we had hired for eight years all they had ever done is sell cheaper insurance with broader terms and all of a sudden they are explaining to clients that carriers have no return and they are having to become more sophisticated in how they explain how insurance works to clients and its been quite impressive and I do think that as long as yields remained suppressed, you are going to see carriers that fight hard to try to cover their cost of capital.

Doug Howell

Yeah, in terms of debt Brian, I think that, let keep those $200 million put to bad and then what we need to look at little bit of longer term, it doesn't paid right now to do that at this point, but if we have a little bit of trough in rates still for the rest of the year, we would look at doing something with our 2017 tranche.

Operator

(Operator Instructions) Our next question comes from the line of Bob Glasspiegel of Janney Montgomery Scott. Please take your question.

Bob Glasspiegel - Janney Montgomery Scott

Pat, in light of your expense cuts, are you changing the dynamics of the 3% organic been the breakeven of margin hurdle?

J. Patrick Gallagher, Jr.

Bob, great question and yes, you should look at that, it's in the past I have said that it takes 3% to cover the natural inflation that goes on inside of our book, if we believe we cut that natural inflation by this reduction enforce then it would stand to reason that we probably could have margin expansion at less than 3%, so you are providing the linkage there.

Bob Glasspiegel - Janney Montgomery Scott

I have next seen recovery from restructuring charges so dynamic 200% plus ROI how does that phase in?

J. Patrick Gallagher, Jr.

It’s immediate.

Bob Glasspiegel - Janney Montgomery Scott

So its $35 million, I mean, I didn't know that was annual cost or cumulative cost recovery?

Doug Howell

No that's our one time severance cost we expect to harvest $35 million of savings.

Bob Glasspiegel - Janney Montgomery Scott

$35 million accumulative or $35 million a year, I guess that's what I was…

Doug Howell

Per year.

Bob Glasspiegel - Janney Montgomery Scott

$35 million per year.

J. Patrick Gallagher, Jr.

Which will offset additional costs Bob, don’t drop that in the EBITDA.

Bob Glasspiegel - Janney Montgomery Scott

No I wasn’t, but I just wanted to make sure I understood your recovery. So that's evenly in the first quarter, your run rate is down by 8.5 million a quarter and you are going to spend some of that on inflation.

Doug Howell

Correct.

Bob Glasspiegel - Janney Montgomery Scott

Okay. On the, it sounded like Pat for (inaudible) port cycle that we've had together, you are more bullish for this cycle than I have heard you on the environment, is that a correct read or…

J. Patrick Gallagher, Jr.

Yeah Bob if I can get mid single digit increases in rate and if our clients businesses can recover to even a 2% economic growth, with our new business machine we will show very solid organic growth which is what showed up in the fourth quarter and if you give me 5% to 8% organic growth and I'm not predicting 8% right now, but if you see a real change in the economy and rates stay affirming you can show some real growth at the profit line.

Operator

Our next question is coming from Ray Iardella with Macquarie.

Ray Iardella - Macquarie

Just a couple of numbers question because I guess a lot of the topics have been covered already, but maybe Doug can you talk about the tax rate on the core business, I know we spent some time talking about the clean energy initiatives, but it seems like you guys maybe are expecting a lower tax rate going forward.

Doug Howell

Yeah, good question Ray if you read in our press release and income tax section we have moved historically we would say 39% to 41%, we are kind of south of that now. That has to do with the mix of our international business. As we grow internationally the tax rates in those jurisdictions are less than what we have here and so that does have a tendency to bring down the rate.

Ray Iardella - Macquarie

And then I know you mentioned the one large client on the risk management side, margins around 16%, but any other sort of drag you guys expect in the first quarter from bringing some of those hires online.

Doug Howell

No I think actually we should hit the ground running with respect to our South Australia clients, so I don't expect it to drag.

Ray Iardella - Macquarie

And then international versus domestic cash do you have that.

Doug Howell

Yeah, we have about 40 million free in the US and about 120 million internationally. So when I gave the 160 million in free cash, its about 40 in the US and a 120 internationally.

Ray Iardella - Macquarie

Okay and then I think I missed the number at the very beginning Pat in your prepared remarks, where you talked about you know $232 million of acquisitions that you guys did in 2012 but what was the expectation for 2013 for those acquisitions.

J. Patrick Gallagher, Jr.

A $130 million.

Doug Howell

The roll over rate.

J. Patrick Gallagher, Jr.

That’s the roll over.

Operator

Our next question is coming from the line of Joshua Shanker of Deutsche Bank.

Joshua Shanker - Deutsche Bank

Doug can we talk a little bit about ace of plants coming online throughout 2013 comparing the early part of the year to the late part of the year.

Doug Howell

Just say your question again. You beeped out on the first part of the question.

Joshua Shanker - Deutsche Bank

Sorry ace of expectations for the pace of plants coming online.

Doug Howell

The pace that we have in here is, if you add up the ultimate numbers on page six, you get a number higher than what we have on page 14 of the investor supplement. So what that would imply is that the pace is probably a three months set back. So if you think about the pace of these plant coming on, not going to each one of them, but we have two that we think is going to be in mid-2013 and then the ones that were currently like we have been selected as the finalist, those would come up in the fourth quarter if that works. So I think the pace on six rather than going through each one is our best guess, but we’ve given our selves a few months cushion age of those pieces.

Joshua Shanker - Deutsche Bank

Okay, and Pat, you said a word that I talked about a lot, but I don’t hear a lot. Self insurance as at protection for your clients to avoid paying higher rates. Towards that can you see now and forecasting if we are in this continues rate environment that self insurance becomes a larger part of the pie.

J. Patrick Gallagher, Jr.

Every single cycle, every single cycle it does and in particular, the workers compensation line. Workers compensation is running very high. Combined loss expense ratio for the industry as a whole, something on probably north of probably north of 115%. That’s going to create a natural push from the carriers to increase workers comp premiums and those will be offset by people who will join pools, find together to create ways to self insure. It will take individual clients that will form captives or group captives and you will also see just individual clients that are on the cusp, taking more risk themselves, working harder at loss prevention and trying to not pay the premium but pay the losses themselves. This is our wheelhouse. This is what built our company. We got in to this in the 60s and in every single cycle, this is what expand for us greatly and that really benefits Gallagher Bassett as well as the brokerage side. Now remember part of that is a little bit self defeating on the brokerage side, because if we are writing an account with a very high commission that then take self insurance and takes a huge retention, our commission has actually come down. The fees on the Gallagher Bassett side our new fees that we didn’t have, but those are little bit lower in terms of margin. Nonetheless it’s the right thing to do for our clients and we are really, really good at it.

Operator

Our last question is coming from Brett Huff of Stevens. Please state your question.

Brett Huff - Stevens

Two questions Pat you said all in you guys end up sort of squeezing the rate down to 1% on brokerage, should I just to do the math and that implies a 4% in terms of unit growth?

J. Patrick Gallagher, Jr.

Yes.

Brett Huff - Stevens

Okay. And the second one and you mentioned Doug a little bit on this in terms of the acquired revenue seasonality and in terms of a little bit lower margin and I don’t know if Doug or Pat is best one for this, but more generally in the just really big push you guys have done on M&A, have those new businesses you acquired come in at a lower margin and if so what is your expectation for expanding that margin to get back to a higher level or your average level or whatever can you sort of give us a sense of that?

Doug Howell

I think of the portfolio of acquisitions if you look overtime, they come in not that dissimilar to us. So I wouldn’t say that the fuel margin or depressed margin, you can get some quarterly anomalies like we talked about here, but by and large they look a lot like us and that’s an important strategy of our M&A strategy. When it comes to most of these deals, we want to buy successful, growing entrepreneurs that know how to run a business to make money for themselves and because we want them to make money for us together as a combined organization, we try not to ever buy small deal that’s a turnaround, we try not to buy retirements, we want to buy people, we want to continue to produce for us, and that they have shown that they can make for their family. If they don't make money for their family, they are never going to make money for us when they come in. So buy and large these are successful entrepreneurs that run margins that are on par with ours.

J. Patrick Gallagher, Jr.

In some instance it is better than ours.

Brett Huff - Stevens

Right, and there is nothing about this, the truant, the big truant that you guys acquired this year that's better or worse than that sort of historical view?

Doug Howell

No, the truants that I am talking about, they just were seasonally smaller in the fourth quarter, full year they are on par with us.

Brett Huff - Stevens

Okay, that's what I needed, thanks again.

J. Patrick Gallagher, Jr.

Christine is that it for questions.

Operator

We have no further questions at this time.

J. Patrick Gallagher, Jr.

Great, let me just make a brief wrap up comment then. Again thank you all of you for being on the call this morning, we appreciate it. As you can tell we are pleased with our 2012 results, we are excited about 2013; we believe we got a solid strategy. We have a team that we believe the second to none and we look forward to continue to grow the enterprise in 2013 and beyond. So thank you again for being with us. Thank you Kristine and that we will end our call today.

Operator

Ladies and Gentlemen, this does conclude today's teleconference. You may disconnect your lines at this time.

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