Arthur J. Gallagher's (AJG) CEO Patrick Gallagher on Q2 2014 Results - Earnings Call Transcript

| About: Arthur J.Gallagher (AJG)

Arthur J Gallagher & Co. (NYSE:AJG)

Q2 2014 Earnings Conference Call

July 30, 2014 9:00 AM ET

Executives

Patrick Gallagher – Chairman, President and Chief Executive Officer

Douglas Howell – Chief Financial Officer

Analysts

Sean Dargan – Macquarie Research

Adam Klauber – William Blair

Sarah DeWitt – Barclays Capital

Mark Hughes – SunTrust Robinson Humphrey

John Campbell – Stephens Inc.

Dan Farrell – Sterne Agee

Meyer Shields – KBW

Kai Pan – Morgan Stanley

Charles Sebaski – BMO Capital Markets

Michael Nannizzi – Goldman Sachs

Operator

Good morning, and welcome to Arthur J. Gallagher & Company's Second Quarter 2014 Earnings Conference Call. (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 certain risks and uncertainties that will be discussed on this call and which are also described in the company's reports filed with the Securities and Exchange Commission. Actual results may differ materially from those discussed today.

It is now my pleasure to introduce J. Patrick Gallagher, Chairman, President and CEO of Arthur J. Gallagher & Company. Mr. Gallagher, you may begin.

Patrick Gallagher

Thank you, Christine. Good morning, everyone and thank you very much for joining us this morning. This morning I'm joined as normal with by Doug Howell, our Chief Financial Officer; as well as the heads of our operating divisions.

I’ll make some comments on the quarter, add some perspective to our press release, discuss our mergers and acquisitions, discuss the rate environment, and give my thoughts on how I feel about future, then I will turn it over to Doug to make some comments and we’ll go to questions and answers.

I just have to tell you, I could not be more pleased with our second quarter that I am, this is unbelievable. What our team accomplished is just outstanding. On April 1, we announced our acquisition of Oval in the United Kingdom.

In April, we entered into an agreement to acquire Crombie Lockwood in Australia, New Zealand and we closed it June. We issued a secondary offering and raised just short of $1 billion in April and we did a $700 million debt offering in June and with all that going on, we completed 17 total mergers including the ones I just mentioned for almost $500 million in annualized revenue. We grew our adjusted brokerage revenue 34%, we grew adjusted brokerage EBITDAC at 43%, expanded our brokerage margin of 190 basis points through our Risk Management revenues of 8% and grew Risk Management EBITDAC 9%.

Our organic growth in the quarter all in our operating units was 4.4%. Brokerage base commissions and fees were up 3.1%. Our brokerage supplemental commissions were up organically 9.1%. Our brokerage contingence commissions organically were up 9.7% and our Risk Management organic growth was 7.6%. By all measures, a terrific quarter. I just could not be prouder of our team.

Let me discuss mergers and acquisitions. 17 mergers completed in the quarter is incredible work by our team. Remember, in order to get 17 mergers done in a quarter, we have to show these successful entrepreneurs why they’ll be more successful after the deal is done with Gallagher than either going it alone or with another strategic partner.

As competition for these firms and they chose Gallagher. I say this every quarter, welcome to our new partners and thank you for choosing Arthur J Gallagher & Company, welcome to our growing Gallagher family.

We’ve been a very active acquirer for 28 years. We’ve built our company by finding compatible firms and proving that one plus one can equal three, four, or even five. What we have accomplished in the last couple of years has truly transformed our company. Consider this, we bought Heath to get it started in the UK retail. This led to Giles, Oval and other bolt-on acquisitions making us one of the top brokerage firms with over 70 offices throughout the UK.

We became the largest broker in New Zealand. We joined the top five in Australia. We joined the top five in Canada. We continued our merger and acquisition strategy in the US maintaining our spot at number three. And let me say this about the firms that we have acquired.

There are middle-market, niche focused, producer-centric insurance brokerages right in our sweet spot. And I’ll tell you, once they join our company, they are like kids in a candy store when they get access to the resources and capabilities that Gallagher brings to them.

We have built a truly global platform with all of our people committed to responding to our clients and prospects needs utilizing our top talent wherever it resides around the world without any barriers.

Our integration work streams are all on track, we are winning new accounts, serving our existing client base and we continue building out our world-class company. And the thing that’s incredible is that our pipeline for acquisitions remains very, very strong.

Let me move to the property casualty rate environment. We did a mid-year survey of our property casualty renewals and you’ll read in that release that it shows about a third are getting increases about a third are flat in terms of rates and about a third are getting decreases. So let me peel that back a bit.

First recognize it’s really tail two markets, property and casualty. So I’ll talk about property first. 20% of our clients in the property arena are renewing up. But these are single-digit type increases. 25% are seeing no change in rate, 40% are renewing down, but single-digit type decreases and that about 20% are renewing down with decreases greater than 10%. And frankly this is not unreasonable given the fact that we’ve had no real major catastrophes in the last few years.

As for domestic casualty lines, we are seeing what I consider to be rational account and coverage underwriting, 40% of those clients are renewing up, but these are single-digit type increases. 30% are showing no change in rate, 30% are renewing down, but again, single-digit type increases and very, very few casualty renewals are getting decreases greater than 10%.

Beneath that, we are seeing workers comp, commercial auto, and professional lines more moving on the upside, general liability an umbrella of more flattish to slightly down. Internationally, as for the UK, we are seeing a similar property rate pressures in the US and casualty lines are flat to slightly down.

However it’s important to note that there really wasn’t much of a firming market over the last several years in the UK, so we believe underwriters are beginning to take on a more disciplined underwriting approach and are asking for some inflation level rate increases. In Canada, a similar story, the property rates are not as challenged as the US because of a couple of large weather events in the last year.

In Australia and New Zealand, property is up single-digits, casualty is flat slightly down and carriers are not really showing any inclination for price increases. Remember this is important.

Over the last three to four years, our results have been influenced by rate and exposure growth by less than 1%. Our professionals help our clients mitigate costs and they are very, very good at it. We do not need rate increases to grow this company.

Give us a flat rate environment and AJG will sell a lot more business than we lose. We are a sales machine. Everyone at Gallagher understands, nothing happens till somebody rings the cash register. I believe today’s environment shows continuing discipline on the part of our insurance carriers.

All of our major trading partners have been telling us for years they want to account by account underwrite. In other words what they are saying is, if the account deserves a rate cut, give it to them. But if it needs an increase, get it. And we are seeing that discipline continue in the market. I do not feel any lessening of that discipline. I realize there is rate pressure on lines that have produced significant returns to carriers and frankly that’s only fair to our clients.

So, I believe this is anything but a soft market. In fact, it’s a great environment for us to grow the business going forward. Let me talk a little bit about our benefits business. Our employee benefit brokerage business continues to pose some of our best organic growth and margins and also has a robust pipeline for acquisitions. And we are right in the middle of one of the most complex and constantly changing challenges basing American businesses which is the new Healthcare Act.

This presents us with new opportunities to demonstrate our capabilities to existing clients and prospects. It’s also important to note that medical insurance is just one portion of what we provide to our customers. We offer solutions to the full spectrum of problems around controlling benefits cost, retaining expedite and productive workforce and offering a range of retirement alternatives.

This is – it’s just a terrific business for us. Let me move to our property casualty wholesale operation which we brand as Risk Placement Services, as a domestic wholesaler RPS has impacted significantly in the quarter by the rate environment. However, we continue to grow our business nicely and the programs in the MGA arena. Our underwriting expertise continues to deliver solid revenue growth and contingent increases.

And finally, I want to talk about our Risk Management business which is Gallagher Bassett. We see excellent growth opportunities around the globe. In the US, we continue to enhance our base workers compensation product with unmatched loss control analytics.

In the UK, we have tailored our systems and processes allowing us to move from a strong position with governmental customers to commercial customers and in Australia our development of new IT solutions has positioned us to increase our market share with governmental work care covered programs.

So, by and large, a terrific quarter. Operations are getting stronger every quarter and I want to talk just a little bit about the future. I think that we are positioned for a terrific close to 2015 barring any change in the economic environment or the rate environment. We should have a solid end of this year and I think we are well set up for 2015. Doug?

Douglas Howell

Thanks, Pat, and good morning, everyone. It's really nice to report a solid quarter and a solid first half for that matter. We'll start on the first page with the Brokerage segment. Our top-line $0.66 per share was aided nicely by the addition of Crombie/OAMPS which we closed on June 16. You read at the top of Page 4 that it added about $0.06 to EPS and now that they earn about 60% of their second quarter earnings in the latter half of June.

So that was great work by the team to get closed fast enough to nearly overcome the seven-tenth of dilution that arose in the 60 days between the secondary stock offering in April and the close on June 16. That’s really good work to the team.

Moving down, you’ll see the integration line which is in line with our forecast, and you heard Pat say that our efforts are going very well.

Staying with brokerage, but turning to Page 2, to the organic revenue table at the bottom. First, while we continue to believe that transparency into the components of brokerage revenues that’s base supplemental and contingent is that we believe that’s important and useful, please remember that our mission is to work hard on growing all three.

We encourage our team to get appropriate compensation for our services and not to worry at all about where it gets classified on our financial statement. Second, underneath the organic numbers, our global retail operations grew nearly 4%, yet our global wholesale operations were about flat. Within retail benefits were a touch better than the P&C business and within wholesale, those operations in particular felt pressure from the property market as Pat said.

Property renewals are seasonally skewed somewhat to the second quarter, so we don’t see much – such a level of headwinds coming into the third and fourth quarter related to property. Third, let me add a bit more to Pat’s statement that historically, the firming rate environment wasn’t contributing much organic, basically less than 1% of our organic growth.

You’ll read on the first page of their earnings release that the property rates negatively impacted commissions, but casually rates had a positive impact. Numerically, property pulled down our overall organic by about 80 to 90 basis points and casualty helped our organic by about 20 to 40 basis points.

So you can see the headwind there on the property side.

Let’s move to the brokerage comp operating and adjusted EBITDAC margin tables on Page 3. You’ll see that we have added in the footnote to each table the impact of the four larger mergers we completed since last year second quarter.

The punch line is that those four deals in aggregate bolstered our margins by about a 140 basis points and we got another 50 basis points of margin expansion from the balance of our operation. We think that’s terrific in this environment.

Now, looking over the next couple of quarters, please note that the four larger deals and now with the Canadian operation closing on July 2 in aggregate our seasonally smaller in the third quarter and will actually produce a drag on overall margin of about 40 basis points. That flipped in the fourth quarter and that will actually bolster overall margins by a point to a point and a half.

Moving to the brokerage segment non-cash line items for the remainder of 2014. For amortization assume about $48 million of expense per quarter. And for acquisition earn out amortization, assume about $4 million of expense per quarter and depreciation were around about $14 million of expense per quarter.

Then as we do move on M&A, for every dollar we spend, you’ll need the increased amortization about 1% of the purchase price per quarter now get to pretty close.

All right, let me shift now to the Risk Management segment on Page 4. Across the board, a great quarter. Revenues up 8%, margins nicely above our 16% target. They are doing well integrating the carrier book and we are still making a lot of client-centric investments at the same time.

Looking towards the third and fourth quarter, please note that we’ll give back a little of that margin, because as we have said before, we are holding ourselves to a 16% margin target for the year. After non-cash items, the Risk Management segment and I just assume about $7 million a quarter for depreciation and about $1 million a quarter of amortization.

Let me shift to Page 5 to the corporate segment. In aggregate, right in line with the mid-point of the range we gave last quarter. However, when you look at the separate lines, you will see that there was a strong quarter from our clean energy investments that cover the additional M&A costs that we spent to close the UK, Australia, New Zealand and Canadian operations.

Looking forward, as you know when modeling the corporate segment, we encourage you to use the shortcut table format we provided on Page 14 of our investment supplement. Not a lot of movement since the first quarter and in terms of our guidance looking out for the next few quarters. But as I say, when it comes to clean energy, earnings for the year can be difficult to predict, so it does have a wide range. Please make sure you consider that when you are doing your model.

Finally, some comments on capital management, with our secondary in April, and in the debt raise in June behind us, as we look out towards the end of 2015, we would like to have our net-debt-to-EBITDAC ratio back down into the low 2X position.

That said, our free cash flows, the dribble out shelf we have, our line credits and the ability to use stock in tuck-in acquisitions, we’re still well positioned to continue our smaller tuck-in M&A program for the rest of this year and well into next year.

And as you’ve heard Pat say our pipeline is full. So we won’t have any problem keeping busy. So, when I step back and take a look at it from the CFO’s chair, we are doing really well, organically, carriers are actually pricing on account and line of cover basis. The economy is moving forward.

We are working hard on integrating the larger M&A operations and having success there. We are still closing a lot of smaller tuck-in acquisitions and we have an exciting – we have a lot of exciting operational improvement and productivity initiatives going on. And our culture is variety. So let me simply put, I think the team is delivering on all fronts.

Back to you, Pat

Patrick Gallagher

Thank you, Doug. As Doug said, I think we are hitting on all cylinders. And with that Christine, we’ll go to questions and answers.

Question-and-Answer Session

Operator

Thank you. (Operator Instructions) Thank you. Our first question comes from the line of Sean Dargan with Macquarie. Please proceed with your question.

Sean Dargan – Macquarie Research

Yes, thanks. Doug, I guess, first thanks for breaking out the impact of raising equity early in the quarter and not really layering in the earnings till the end. I am just wondering what your thought process was around pulling the trigger at that point on the equity raise versus really.

Douglas Howell

Simply that, we are committed to do that with Wesfarmers on the deal since we committed to do an all-cash deal with them and frankly we just didn’t want to get caught between the boat and the dock having a large equity raise sitting out there for 60 days waiting to get done.

So we sat down with our advisors and they thought it was a good time to go. It wasn’t a bad time in the market given the financial sector that weak, but I was really happy to get it done and get it behind us.

Sean Dargan – Macquarie Research

Great, thanks and what’s your view on using the market option that you have available to you and what factors into using that to I guess, fund further acquisitions?

Patrick Gallagher

Well, first of all as we mentioned, it’s not very much, it’s only – what we have left down is a $196 million on it. So it’s not like it’s that bigger, but of a shelf sitting there. Typically, if we have in the international deal that’s a little bit more difficult to use our stocking acquisitions if we choose to do that.

So we’d probably use the dribble out if it comes up in order to do smaller tuck-in international deals or they aren’t necessarily positioned well to take our stock in the deal. But it’s there, just as a liquidity measure.

Sean Dargan – Macquarie Research

Thank you, very much.

Douglas Howell

Thanks, Sean.

Patrick Gallagher

Thanks, Sean.

Operator

Our next question comes from the line of Adam Klauber with William Blair. Please proceed with your question.

Adam Klauber – William Blair

Thanks, good morning guys. Good quarter.

Patrick Gallagher

Thanks, Adam. It was a great quarter, Adam.

Adam Klauber – William Blair

Sorry, Pat. Couple different questions. How is organic outside of the US?

Patrick Gallagher

Internationally, Adam, organic is – last year at this time, we are running at about 10% organic if you go back and listen to it. But it’s basically running about the same as our domestic operations right now. And if we are going to look for any particular soft spot in international, I would say that then a very small affinity programs we had kind of a game buster quarter last year on it, that didn’t produces quite as much as we reach with some products there. But by and large, we are having some nice large account wins there, but if I were going to try to break it apart, that’s where it would be.

Adam Klauber – William Blair

Okay, okay. And then – and you mentioned, RPS clearly does a lot of property CAT, does that have an impact on organic coming down this year compared to last year.

Patrick Gallagher

Oh, yes. That’s why I made it – in my prepared remarks, that’s why I mentioned it. I mean, our biggest quarter for property placements is the second quarter and property is one of our largest lines in the quarter and it was impacted by probably over 10% reductions.

Douglas Howell

Yes, that’s the one thing caught it just a little bit flat, but if I were going to back and look at our expectations, just a slide in the property market and how it impacted to be – to pull our overall down 80 to 90 basis points of organic. I guess, that’s looking on the bright side of it casually rates still being up mitigated some of that overall. But that’s the one that, I’d probably wouldn’t have been able to predict that six month.

Patrick Gallagher

To put this in perspective, Adam, we are the largest placer or excess and surplus property risks in the State of Florida.

Adam Klauber – William Blair

Right, yes, and I know RPS is one of the biggest property acquirers out there and they are very – extremely good.

Patrick Gallagher

And by the way, this is completely appropriate for our clients. There is no – about this. They deserve a decrease. They paid up big time after the last catastrophe and this is what the market should do.

Adam Klauber – William Blair

Yes, I know, again, it’s normal up and down. What was – what kind of in your access in Wesfarmers, clearly they’ll not include in organic, but how are those organizations doing on an organic basis?

Douglas Howell

New Zealand doing terrific, Australia, hanging in there kind of flattish from what I can tell, the measurements are little different because as we pull those companies out of where they were before, and Canada is on fire. We think that there is good results up in Canada.

Adam Klauber – William Blair

Great. Great and one more question on Wesfarmers, Wesfarmers – particularly I mean, both good sized organizations out of the US. How are you changing your management structure? How you are staying on top of those organizations?

Patrick Gallagher

Well, I mean, first of all, Adam, at the detailed level of integration process management that we have is, it’s really unbelievable. It’s like being in a construction truck on a job site. We know every single item that is supposed to occur every single month whether it be a lease renewal or whether it be some account that should be transferred from a different London brokerage into our London operation.

And those work streams are laid out way in advance. These organizations remember, they are very similar to what we’ve been building here in the United States. We got terrific leadership that has been doing acquisitions of bolt-on acquisitions over the last decade. So I said in my prepared remarks, these are niche focused, producer-centric organizations that look and feel just like us.

And they fold into our organization nicely. I mean, in terms of how we manage them, they report into our structure through our international business, but it’s headed by my brother Tom Gallagher and by our CEO in the UK, David Ross and we fold them and move on just like we’ve done for the last 30 years.

Douglas Howell

Adam, deals on the back-office side, as you know that there is strong reporting as we manage that, and so what I’d say that the non-production layer, they are strong reporting response lines between the CFOs and me the IT folks and Eric Dean our Global IT leader.

So when you look at it, there is the production side of leadership and then there are local management leadership. They are responsible for everything. But with reporting in every reports into their kind of functional leader also. So, just illustratively, for the first 60 days, I had a call almost every day with a CFO of Australia, highly confident for those that might have met her on the secondary road show. Just a terrific, terrific CFO there illustratively.

Adam Klauber – William Blair

Okay, that’s very helpful. Thanks.

Patrick Gallagher

Thanks, Adam.

Operator

Our next question comes from the line of Sarah DeWitt with Barclays. Please proceed with your question.

Sarah DeWitt – Barclays Capital

Hi, good morning.

Patrick Gallagher

Good morning, Sarah.

Sarah DeWitt – Barclays Capital

On the three big deals that you’ve done this year, could you give us an update on how the integration is going? Are you on track to achieve the synergies and could there be any upside there?

Douglas Howell

Well, let me hit that. The integration side of it now uses an illustration Bollinger. When we bought Bollinger less than a year ago, they are up completely on our agency management systems. We’ve all of their centralized payables have been moved into our operations already.

All the carrier payables have been moved into our central core. We’ve got a ton of their real estate consolidated. The teams are working together and the last thing that really needs to go up is just the phone system to go up on our Voice-Over-IP system.

It’s pretty well up, but we’ve got some tweaking to do on it. Clearly, none of these things happen without a lot of hard work. I just want to make –maybe with this opportunity to talk, we understand that we’ve got professionals around the globe that are – their sole job is to integrate acquisitions.

They’ve got the integration experience. They are assigned full time to the process. And also, together our company that has done so many acquisitions, almost all of our systems are built. That’s not only systems but also processes are built to plug in new partners and new organizations into our system. So it’s not like we have – I’m going to use this is word closed architecture that isn’t receptive at all for new partners.

So that is – basically you can plug and play the new operation. So that’s going – Bollinger illustratively is going very well. Similar stories with Giles and Oval in the UK. But remember in Canada and Australia too, we are basically using their system. We don’t have overlap to it, really any degree in New Zealand, Australia and Canada. So, we are basically going to be using their systems. So there is not a lot of integration that goes along with it. So…

Patrick Gallagher

Let me take the ball and a little bit, Sarah, on the different angle. What I look at is selling and holding on to clients. Right, so what I am really pleased about is with Noraxes is an example. We have already got people and resources from the US in areas like mining and natural resources, working together with our new offices in places Nova Scotia, working on clients.

That is exciting. We are already writing new business throughout Australia on areas that in places that we didn’t have an opportunity before, but with our capabilities now, our people are out calling on clients, saying, hey, this is a whole new world and that’s what is the bell weather to me. Are we holding on to clients? Are we selling more new business? And if that’s the case, that generates excitement and in all three cases, the UK, Canada, Australia, New Zealand, very, very good energy.

Douglas Howell

And then, financially, there is nothing that makes me think that we won’t see our expectations be realized on these financially. So, I think they are delivering to our early measures, there is still lots of synergies and frankly, as we start working more and more with them, we see tremendous opportunities.

If you look in the press release to the operating expense table, actually, there we put a footnote in there, the fact that these larger deals run kind of higher operating expenses than what we do.

That’s a great opportunity for us to go in there. It doesn’t really impact the people are doing the business we’ll just be able to procure goods and services, will be able to use our offshore centers of excellence better, will be able to our volumes purchasing, health. So, I feel that is a great opportunity to realize our synergies.

Sarah DeWitt – Barclays Capital

Great, that’s a great answer. And then, secondly on the insurance brokerage organic growth, I know you said that prices were flat, you still grow organically. But if we were to look out a year and prices are down mid single-digits, is that still an environment where you think you can grow organically and expand margins?

Patrick Gallagher

Absolutely, again, in my prepared remarks and in Doug’s remarks, we mentioned the fact that even with rate increases in some instances up 5%, 6% over the last three years. The impact on our results has been less than 1%. So our people do a good job of helping our clients renew coverages at cost that are less than what’s been requested, that’s by change in deductibles, changing structure, et cetera. So, if the market is flattish to down single-digits, we’ll do great.

Douglas Howell

Remember, some of our clients they are still not buying to our recommended level of exposure cover. I mean, there is lot of on that during the great recession opt to not have covers that they are going to take the risk on. We still see lots of opportunity for our clients to.

If there is a slight rate decrease, we will pick up that plus reduce the deductible of that that will increase the top end, Maybe you think about buying another line or two that you opted out.

So that’s what our guys are doing there. Every day they say, is your insurance program matching to your risk appetite and then decreasing prices that people tend to buy a little bit more insurance which kind of knocks the downside off of that a little bit. So, we see good opportunity for it in this up two, down two, up three, up down three type environment.

Sarah DeWitt – Barclays Capital

Okay, great. Thanks for the answers.

Patrick Gallagher

Thanks, Sarah.

Operator

Our next question comes from the line of Mark Hughes with SunTrust Robinson. Please proceed with your question.

Mark Hughes – SunTrust Robinson Humphrey

Thank you. Hey, Pat that was a fabulous quarter. Congratulations.

Patrick Gallagher

Hey, Mark. Good start.

Mark Hughes – SunTrust Robinson Humphrey

The – would it be possible to share the – just rough percentages of property, the revenue from property in 2Q versus what you would see on a full year basis, so we get a better sense of that seasonality?

Patrick Gallagher

Yes, I think that property, if I look at it and our brokerage business, let me give my sheet here that – let’s stick with wholesaling that in the second quarter wholesaling really 60% of their property placements come in as a percentage of the revenue come in the second quarter and you are down into like the 30% or 40% range in terms of their mix.

And when you look at overall, and you are seeing kind of 30% to 35% as a mix of business in the second quarter but the rest of the year property comprises maybe 20%. So there is a – depending on which business, but overall for us, the mix of business is, maybe 30% of our business in the second quarter and then 20% for the remainder – for the other quarters during the year.

Mark Hughes – SunTrust Robinson Humphrey

And then, revenue seasonality within the acquired businesses are – I’ll ask that question then I’ll also ask under the circumstances, any just general commentary about the 3Q EPS if you did roughly $0.80 this quarter.

How should we think about the Q3, you’ve given us some ideas on the margins and that’s appreciated, but just given the magnitude of the movement in the business this quarter. How should we think about the Q3 relative to the number that you just put up?

Douglas Howell

Well, we’ve always shyed away from providing any EPS discussion with respect to our Brokerage and Risk Management segments. So, I hate to say a few markets, I’d rather not do that. In terms of how we see seasonality, with respect to the bigger deals, like I said in my comments, we see maybe a 40 basis point drag on margins in the third quarter because of the lower seasonality of the big – four actually the five acquisitions that will be in our numbers in the third quarter this year.

And then in the fourth quarter, we see that to be a point to a point and a half up and then when you get out to next first quarter, they have an impact of greater than 150 basis points margin expansion. So, I’d rather not comment on EPS. But there is seasonality in those larger deals and I think if you run it through your models, I think you’ll get to a pretty close answer.

Mark Hughes – SunTrust Robinson Humphrey

Okay, thank you.

Patrick Gallagher

Thanks, Mark.

Douglas Howell

Thanks, Mark.

Operator

Our next question comes from the line of John Campbell with Stephens. Please proceed with your question.

John Campbell – Stephens Inc.

Hey, Pat and Doug. Good morning.

Patrick Gallagher

Good morning, John.

John Campbell – Stephens Inc.

Great quarter.

Patrick Gallagher

Thank you.

John Campbell – Stephens Inc.

So, good Risk Management results, I’d say particularly on the margin line. So, just first, what’s driving that near 17% EBITDAC margin? And then Doug, I know, you guys said, you are still targeting the 16% for the year, which does imply little bit of dating over the back half of the year. So just still assign on some of them that’s opportunity in risk and then maybe just assuming greater scale and maybe even tapering investments which you guys see as peak margins longer-term?

Douglas Howell

Well, then I think that business longer-term we like 16 to 17 points of margin in the near term. All right, so we think this is kind of a – we are at kind of full margin on that business. Again to expand margin on that business, you really need at least 5% to 6% organic growth to expand. It’s not quite as leveraged as it is on the brokerage side.

Or we say, you need 3% or more in order to expand margins. So, for us, the back half of the year purely it’s the amount of investments we want to make in modernizing our product offering, enhancing our quality, improving our productivity and then adding product lines to – services to our customers.

So, the reason why we – we are above 16 points of margins and the team held off a little bit in making those investments until we see the organic showing up and it did at 7.6%. So, the rest of the year, we’d like them to give back into continuing to make some product enhancements.

Getting ready to rollout of new analytics worked in here over the next – the version three of that, here in the third quarter. But this is just product enhancement, product improvement, client service enhancement and so. And we see ourselves in that mode into 2014 and 2015. A little too early to talk about 2016, but that’s where we see ourselves.

Patrick Gallagher

And John, let me comment. These are world-class margins in that business and the – there is heavy investments in IT and in people. When you bring on a client, a large commercial client or a large insurance company, you better have the people at the desk as the claims are coming, trust me.

John Campbell – Stephens Inc.

Got it, got it. Thanks for that color guys. And then just on a housekeeping item. It looks like that international quarter – the flow through is driving up, the brokerage tax rate down and I might have missed this from earlier from you Doug, but just curious about how to think about that brokerage tax rate going forward? I assume the annualized impact from the recent international deals?

Douglas Howell

John you roll on the lower tax jurisdictions of Canada, get the full impact of the UK with Oval and a lower tax rate again with Australia, you could see that move another point lower in the near term.

John Campbell – Stephens Inc.

Got it. Thanks guys.

Patrick Gallagher

Thanks.

Operator

Our next question comes from the line of Dan Farrell with Sterne, Agee. Please proceed with your question.

Dan Farrell – Sterne Agee

Hi and good morning.

Patrick Gallagher

Good morning, Dan.

Dan Farrell – Sterne Agee

There is going to lot of focus on the large deals, but while you’ve done these, you’ve also been very active in the smaller transactions. And I was wondering if you could just talk about the current environment and pricing that you are seeing on those smaller deals?

Patrick Gallagher

Let me talk about the environment and then I’ll let Doug talk about the pricing. The environment for doing acquisitions just continues to be incredibly strong. And what we see globally is there are literally thousands and thousands of smaller agents and brokers around the world.

Most of these agencies and brokerages are run by baby boomers. It’s clearly their largest asset and at some point in time, they’ve got to monetize our life’s work. And so, the pipeline just regenerates itself literally month-after-month with people that are considering and some of these things take years to get done.

I mean, some will move in a couple months but others will be sort of kicking the tires, looking at whether they want to do it, discussing that with it for literally years. And we just are constantly going through the process of looking for number one, people that know how to run a good business.

We constantly say, if you don’t make money for yourself and your family you won’t make money for us. But if you run a good business, if you are really good at clients and have a culture that fits – another thing people say is, how can you put on 17 acquisitions in a quarter and change their cultures?

We don’t. If the culture doesn’t fit us, 99% of our due diligence, once we get over the fact that they make money is all about whether the culture match is going to be right. And once we get that set, it’s we can literally show how one plus one can equal a lot more than two.

And so, it’s a – I think it’s an interesting business situation right now on a global basis. Our opportunities are literally, I mean, just every single month the list just gets longer and longer people who are talking to. And I’ll let Doug talk about the pricing.

Douglas Howell

Dan, I think that, a good question, we did 14 deals in the quarter for $55 million of revenue that’s back up for about $4 million of revenue per shop. Just terrific sales folks have joined us. We are paying about 7X for that in terms of the pricing. So I see that moving higher not on the smaller deals, I think that’s a pretty fair price for what we are paying right now.

Over a longer time, we’ve kind of always been in the 6 to 7 times EBITDA range. So we see that holding in there. Some of the larger platforms, if they are large geographical folks may won’t pay a little bit more on that, but right in line with what our expectation, nice asset deals where we get amortized the purchase price that brings our tax rate down on those.

So I don’t see a much of a different environment. And I look at the deal sheet, there is hundreds and hundreds of those folks on there. So I see lots of opportunity continue to do that. And the teams are working on it every day.

Dan Farrell – Sterne, Agee

Okay thank you very much.

Patrick Gallagher

Thanks, Dan.

Douglas Howell

Thanks Dan.

Operator

(Operator Instructions) Our next question comes from the line of Meyer Shields with KBW. Please proceed with your question.

Meyer Shields – KBW

Okay, thanks. Good morning guys.

Patrick Gallagher

Good morning.

Meyer Shields – KBW

When you talk – you talked in the past about how 3% organic growth is generally enough to produce margin expansion. Is that the bright sort of threshold for the international deals as well?

Douglas Howell

Great question. I think so. I think that in the – most of the environments in which we are operating there, if you take our perhaps Toronto and Sydney and the operating areas I think have enough low-cost environment and I think growth of 3% or more so is a margin expansion opportunity.

That said, please realize that New Zealand runs terrific margins, Canada already runs terrific margins. Australia, there is opportunity there. That’s where we see the opportunity to grow margin there. And then, most of the places that we see margin opportunity is because of having more volume, so more premiums that we’re writing that we can negotiate better compensation arrangement.

And then also on the operating side, I think there is opportunities in real estate consumables, co-sharing of IT systems et cetera. So, that’s really where we see the margin opportunities in the operating expense line more than in the compensation line.

Meyer Shields – KBW

Okay fantastic. When you look at the major deals you have done over the last year or year and a bit, are you keeping all of the people that you want?

Patrick Gallagher

Absolutely.

Douglas Howell

Yes, we’ve really had good retention there.

Patrick Gallagher

I have to tell you, Meyer, when we’ve been able to buy people from a private equity concern, five years ago I would have said, we didn't really want to do that. I was wrong. When they get a board – a brokerage run by brokers, they like it.

Meyer Shields – KBW

Okay fantastic. Good to hear it.

Operator

Our next question comes from the line of Kai Pan with Morgan Stanley. Please proceed with your question.

Kai Pan – Morgan Stanley

Good morning.

Patrick Gallagher

Good morning Kai.

Kai Pan – Morgan Stanley

Just for the underlying margin expansion for the quarter, Doug, you said about a 40 basis points?

Douglas Howell

50 basis points from the – 190 in total, 50 that came from the underlying business, 140 from the four big deals.

Kai Pan – Morgan Stanley

Okay so it just sounds that 50 – that sort of 50 basis points underlying margin expansion, given that you sort of that was pretty offset by only like 3.4% in organic growth. So, I just wonder, if you maintain 3%, 4% organic growth, do we expect to see 50 basis margin expansion going forward?

Douglas Howell

Maybe, but I think that what field some of our margin expansion this quarter were the increased contingence in the supplemental that have a little bit better impact to the bottom-line. But the big question is, what’s happening with inflation? So, I am not dodging the question. I just don’t know. Right now, wage inflation seems to be under control.

We start productivity, opportunities that we can use productivity less the paper raises that our folks deserve. We saw our opportunities on real estate and consumables, IT systems are getting – there is more demand for IT systems. So, I can’t guarantee if it’s not above 3% that we are going to have margin expansion.

Kai Pan – Morgan Stanley

Okay, great. Then on the acquisition front, you did like four big deals in very short amount of time. Is it time to take a pause, step back and to focus on integration and running your core business? Or are you still accounting on the lookout of – remain for the larger deals? And secondly, it looks like you have been planted your flags around all the major English speaking markets. So I just wonder do you have any appetite outside the – in other markets as well?

Patrick Gallagher

Well, let me answer that, Kai, first of all, yes, it’s time for us to digest and focus on integration. We are doing that every single day. So when I talk in my prepared remarks for work streams, we are on top of what’s going on in every office, 70 offices around the UK, 50 new offices in Australia, New Zealand. A bunch of new offices in Canada. We are looking at that every single day and yes it’s time to digest a bit and we are not looking at any substantial new large deals as we speak.

Having said that, are we open to doing acquisitions? Absolutely, especially, our bolt-on acquisitions around the world, one of the reasons we are excited about what we did in Australia is even with the size that we’ve accomplished in Australia will have less than 5% market share.

Terrific opportunity to do bolt-on acquisitions and we’ll continue to do that in Australia, UK, America and Canada. And those bolt-ons will be, as Doug said, on the smaller side. As it relates to non-English speaking territories, you’ll recall, we took a 21% interest in our Mexican trading partner Grupo CP. We’ve opened a small operation in Chile.

We will continue to invest in Latin America and we look to continue to expand our global footprint. We are a global company. Over 27% of our revenue and 27% of our people are now outside the United States and we see that as a great expansion opportunity.

Douglas Howell

Yes, I think the dimension at size-wise here, just that that we are saying, we think it’s really important to put our toe in the water in some of these other countries. We did that in the Caribbean initially with a small deal we did it in Perth, Australia with a small deal that leads the other opportunities.

But plunging into non-English speaking countries in a large way right now is not on our strategic plan. Putting our toe in there with a nice $4 million to $5 million agency there that we can learn the country, learn the business, get some smarts on the ground there. I think that’s a nice step over the next couple of years.

In the US, when we talk about smaller deals, remember, there are some nice $75 million to $100 million transactions or brokers out there that we think might be coming to market. We would definitely take a look at those.

We don’t see $500 million deals out there, $1 billion deals out there that are really percolating around. So when we look at this, you have to think of us not doing something greater than the $100 million in purchase price. But there is a lot of really nice $50 million, $60 million shops out there that are looking to join Gallagher. So we’ll continue to look at those.

Patrick Gallagher

Remember though, if you take a look at the – this month’s business insurance, if you look at the US top-100 to be number 100 in terms of an agency in the United States you got to be $23 million in revenue. So, couple that with the fact that we believe there is something like 20,000 agencies in America. So that is consistent around the globe as well.

Kai Pan – Morgan Stanley

Well, thank you so much and good luck.

Patrick Gallagher

Thank you, Kai. We make our luck.

Operator

Our next question comes from the line of Charles Sebaski – BMO Capital Markets. Please proceed with your question.

Charles Sebaski – BMO Capital Markets

Good morning. Thanks for getting me in.

Patrick Gallagher

Thanks Charles. What’s up?

Charles Sebaski – BMO Capital Markets

I wanted to know, just sort of follow-up there on the acquisitions on the benefit side versus the broker side and how you see that queuing up?

Patrick Gallagher

Well, that’s a great question. Thank you for answering that or asking that rather. The benefits business right now, let me speak to first domestically in the United States. The new law, basically in my opinion puts smaller benefits brokers out of business.

We have 26 people at our compliance department here in Itasca is supporting our US business and 20 of them are attorneys. I mean, you think about the compliance issues for anyone with a 100 employees or more and that’s a huge number of employers in the United States.

They cannot contend with this law and their brokers and agents can help them. The simple – and they are figuring that out. So our pipeline, as it relates to smart, consulting and broking firms in the United States that realize they need our capabilities is extensive and we are clicking off literally an acquisition almost per week when it comes to benefits.

And these are great firms with great clients who know that they need the capabilities that we have to be able to serve those clients. Those that are recognizing that will die, they will be done in the next decade and so, what an opportunity for us. Internationally, the opportunity to expand our consulting as it relates to benefits in the UK, in Canada, in Australia, New Zealand, those are territories for us that are just wide open.

And I think we offer a great compliment to people who would consider joining us in those regions. And we have been very successful. We had a very nice acquisition closed in the UK this quarter and we are very excited about that. Those are capabilities that will actually help us in the US. So, it’s a great business for us. It’s our next multi-billion dollar business in my opinion. And we provide a great home for those professionals that want to join us.

Charles Sebaski – BMO Capital Markets

Do those international consultant benefits businesses have a similar margin profile to your current business? Or is it different in anyway?

Patrick Gallagher

No, it's very similar.

Charles Sebaski – BMO Capital Markets

Okay and one of you have any color of – in how the cross-selling has been working between – I would especially in the US as you talked about these 100% firms and getting benefits leading into brokerage or vice versa? Any additional insight on that?

Patrick Gallagher

Another good question, Charles. That’s an area that we focus on intensely and it’s significantly improving quarter-by-quarter. And the opportunity is unbelievable. If you take a look at our property casualty brokerage operation in the US and our benefits operation, about 90% of those businesses are not cross-sold. And where both operations are up on salesforce.com and we are looking at that every single week and the opportunities are huge.

Charles Sebaski – BMO Capital Markets

I appreciate the answers.

Douglas Howell

Thanks, Charles.

Patrick Gallagher

Thanks, Charles

Operator

Our next question comes from the line of Mike Nannizzi with Goldman Sachs. Please proceed with your question.

Michael Nannizzi – Goldman Sachs

Hi, thanks. Just – most of my questions have been answered, but I have one question, just in thinking about M& A, can you talk about how your tax credit fact is into M&A decisions and sort of how scalable those benefits are to the extent that you are able to grow EBITDA through acquisitions? Thanks.

Douglas Howell

Yes, I think that the ability to repatriate money from overseas in order to bring it into the US and then not pay the US tax on it. There is opportunity there. We did that with the Canadian deal and we did it with the Australian deal and it brings our multiple down on what we paid by about one turn. So we think there opportunities.

In the US, obviously generating more US taxable income, there is opportunity to use more of our tax credits to do that. We are running up towards $100 million of earnings a year off of that business right now, we think there's still some more opportunities to move that higher.

But, I think after about 2015, 2016, that will kind of be a terminal velocity there. So we see it as an opportunity, but – it’s – we still have done the Australian and Canadian deals without and absolutely. The multiple we paid still was a fair multiple. This was a little bit icing on the cake. We try not to ever do a deal on that, – we’d never do a deal just because we can use more tax credits.

That’s something so you got to get the right deal. But frankly, the ability to grow our US taxable income and use more of our tax credits is an opportunity for us over the next seven years. Remember these programs run out in 2021 and we can produce enough credits maybe to get us to 2023 or 2024. But by and large, it's a nice cash generator to fund these acquisitions for this next six or seven years. But we don't do a deal just because of the credits.

Michael Nannizzi – Goldman Sachs

Now, that’s fair. Great, thank you.

Douglas Howell

Thanks, you Mike.

Patrick Gallagher

Thanks, Mike.

Operator

Our next question is a follow-up question from Mark Hughes with SunTrust. Please proceed with your question.

Mark Hughes – SunTrust Robinson Humphrey

Yes, thank you. Any updated thoughts on the exchange opportunity? Is any business changing hands because of the exchanges, either for you or competitors?

Patrick Gallagher

Mark that's a great question. Let me have that. We take a very strong position on this which is, A. We do have a private insurance exchange that we help to start in partnership with liaison and we offer that as one of the many things that we’ll do for clients.

But we look at exchanges as just more of the same, frankly. I mean, our entire history is, going into client offices and helping them sort through what they should do with their risk and what they should do with their benefits.

And these are new opportunities to move to new combined – new contribution approaches as opposed to defined benefits or defined contribution approach and there are lots of different exchanges. So, really what it does, is it provides again some confusion to our clients.

It's difficult for our clients to sort through all of these options on their own. And so it's just more of the same when it comes to sitting down with clients and helping them sort through what should they do the benefits. And remember, it's not just the health insurance spend that clients are dealing with.

Probably, in most businesses, compensation and benefits is one of their leading largest expenses, right? And benefits as part of that, so what we are helping our clients sort through is, what they do about their workforce.

What’s the strategic approach to keeping their people and making sure that they're giving them the benefits package that’s competitive. That includes health insurance and it may include an exchange and it may not work and that just makes for more work for us.

Mark Hughes – SunTrust Robinson Humphrey

Thank you.

Operator

Mr. Gallagher, we have no further questions at this time. I would now like to turn the floor back over to you for closing comments.

Patrick Gallagher

Thank you, Christine. I just have one very brief thing to say and that is thank you again everyone for joining us this morning. I already said this, but I think it bears repeating. I could not be prouder of what our team continues to deliver, first to our clients and then secondly to our shareholders.

And the thing that’s kind of fun about being in my seat is that while I am pleased with the quarter, I am incredibly confident that this franchise is just getting started. So thank you for being with us this morning. Look forward to talking to you in the quarter.

Operator

This concludes today’s conference call. You may disconnect your lines at this time. Thank you for your participation and have a wonderful day.

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