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

Q2 2011 Earnings Call

July 27, 2011, 09:15 am ET

Executives

J. Patrick Gallagher Jr. - President & CEO

Doug Howell - Corporate VP & CFO

Analysts

Adam Klauber - William Blair

Tate Anderson - Citigroup

Sarah Dewitt - Barclays Capital

Mark Hughes - SunTrust

Meyer Shields - Stifel Nicolaus

Alex Pitchard - Trimaran Fund Management

Dan Farrell - Sterne, Agee & Leach

Bob Glasspiegel - Langen McAlenney

Scott Heleniak - RBC Capital Market

Richard Mortell - Piper Jaffray

Ken Billingsley - BGB Securities

Operator

Good morning and welcome to the Arthur J Gallagher & Company’s second quarter 2011 earnings conference call. Participants have been placed on a listen-only mode. Your lines will be open for questions following the presentation. (Operator instructions) As a reminder, 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 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 Jr., Chairman, President and CEO of Arthur J Gallagher & Company. Mr. Gallagher, you may begin.

J. Patrick Gallagher Jr.

Thank you, Rob. Good morning everybody and welcome to our second quarter conference call. We appreciate you being with us this morning. This morning, I am joined by Doug Howell, our Chief Financial Officer as well as the heads of our operating divisions.

As is our custom, I am going to offer my views on the quarter, Doug will make some comments and we will get pretty quickly to questions and answers. As said in the press release, I am extremely pleased with our second quarter. The results I think were terrific and seem where I think really came through in the quarter.

Brokerage adjusted revenues, up 16%, EBITDAC in the brokerage side up 13%. 2.1% organic growth, then if I added our supplemental commissions, the organic number would have been 3.1% in the Brokerage segment. Risk management adjusted revenue, up 20%. EBITDAC up 19% with 5.9%, almost 6% organic growth and if you combine our two operating segments, we produced about 3.7% organic growth in the quarter.

Everywhere I look around, our enterprise, our numbers are improving. Most of our businesses across the globe contributed to the quarter. I am really proud of the work our team did this quarter and I think that these results show that the strategies we have to grow our company are working. I want to remind the listeners that all of our strategies essentially fall in the four main categories.

First thing, we are out after every day’s organic growth. Secondly, mergers and acquisitions. Thirdly, we are focused on operational excellence and productivity improvement and fourthly, we want to maintain what we believe is a very unique, corporate culture.

So let me touch on each of these categories briefly. Let me talk about the drivers of organic growth this quarter. Driving these results was about a 1 point to 2 point increase in new business over 201o and about a 1 to 2 point improvement in our loss business numbers over 2010. An incredibly competitive market out there and to improve new business and loss business in the face of that competition is really an achievement.

Also I would comment our niche focus I think continues to pay results that clients would want to do business with those who truly understand their business. We have made good progress in the quarter, implementing our sales management software and I hope that this will help us maintain our new business momentum. Rates actually showed some flattening, the PC side in the quarter. Catastrophe exposed property, there is Florida wind, California earthquake, some of the property in the middle of the country where there were bad tornado losses this quarter are all showing signs of increases.

Worker’s compensation in many of the states are also showing increases. Now mainstreet and middle market accounts still are receiving some reductions especially when there is competition, but in many instances we are finding markets are not willing to cut their prices at renewal. As I said if there is competition on good account, we are still going to see reductions and there continues to be a difference in the underwriter’s view between new business and renewals. But the whole market is no longer one of automatic cuts for the clients. Our organic growth I think shows great work by our team. We work in an incredibly competitive environment as I said and I am proud of what we have done.

Mergers and acquisitions are second category of strategic growth, for 25 years we’ve sought to attract the best firms in our industry, to our company through the acquisition process. The second quarter was a great merger and acquisition quarter. We closed 9 deals bringing a $180 million of annualized revenue to the company. Our Heath Lambert acquisition in the UK brought us 1200 new associates and a $158 million of annualized new revenue.

This acquisition fits our international growth strategy extremely well, you will recall Gallagher had a modest retail presence in the UK market which is the third largest retail market in the world. The Heath team is a great fit from a business standpoint. But just as importantly, the culture of the firm fit extremely well. We are excited to have our new teammates aboard and already we are seeing that in many numbers of ways our two organizations will be stronger together that we were apart.

This acquisition adds additional strength to our global operations. We are building a much strong international presence. Remember, we’ve been treating with the network of independent brokers for many years. This has presented us with opportunities to continue to buy and/or take equity positions in brokers outside the US. Recall that over the last few years, we’ve expanded into the Caribbean, Australia, Brazil, Singapore, Canada and the UK.

On the risk management side, we’ve been growing outside the US since the mid-90s in Australia, the UK and Canada. The fastest growing part of our brokerage and risk management segments are international operations. Today roughly a quarter of our revenues and people are outside the US. Gallagher is building out a strong international platform, we are a global player with plans and place to continue to our global expansion. Of course you’ll continue to see us be very active in the United States, but you’ll see additional activity outside US where two-thirds of the world premiums are generated.

In our risk management segment, Gallagher Bassett Services may great headway in the quarter, continuing with integration of GAB Robins. The business has been consolidated, we’ve had excellent account retention, the change in offices and personnel is virtually complete. All the GAB accounts will be converted to our risk-backed system by the end of September. All-in-all, a very successful deal.

As I say every quarter, all of these merger partners had choices. I am glad they choose Gallagher. I think that’s a testament to our culture and I would like to extend a very warm welcome to all of them.

The next category is operational excellence and productivity. We worked hard on expense control again this quarter and we continue to build out our service centers outside the United States. The progress I mentioned with the GAB integration also illustrates our success at operational excellence. And finally our culture, we continue to believe our unique culture based on teamwork, putting our clients first and bringing new business in the door everyday is a significant strategic advantage.

It is our culture that helps us attract new resources to our team and merger partners to our company. Our sales culture is very strong. We presently have about a 150 interns learning about this great business and we hope to recruit many of them as producers to our company.

So the second quarter is in the book, I am always glad that the first half is over. We feel good about the first half of the year, but I believe we have good momentum going into the second half of year. We are on track to post more than $2 billion in revenue this year which is a key milestone for our company.

We did our first billion you will recall in 2002 on our 75th anniversary and the exciting thing to me is that if you talk to our team, I believe that everyone would tell you that we are just getting started. Doug?

Doug Howell

Thanks Pat and good morning everyone. Today I have five comments. My first point relates to the Heath Lambert acquisition. You heard Pat say and I certainly agree, we think this is a great deal for us as we expand internationally. So to help you incorporate Heath into your models, on page four the earnings release, we give you the standalone pro formas that we used when we struck the deal. As we integrate Heath and our other UK operations into one unit, it will be nearly impossible to track these operations on a standalone basis in the future. So we won’t be able to update that information in the future. But we hope it is helpful as you build out your models.

Next some voiceovers on the two nearly offsetting items related to acquisition earnout. On one end, we booked about $4.4 million of income as we adjusted downward our estimate of the amount that we will ultimately pay for the 2009 deal with Liberty. This accounting arises because in 2009, we estimated the ultimate earnout obligation a little above the midpoint of the range, but now it looks like we’ll come in a little below the midpoint. Regardless of our estimates, this has really trained out to be a fantastic deal and it also illustrates why it was so important for us to put nearly 70% of the purchase price on an earnout.

On the other hand, we booked about $5.8 million of earnout-related compensation expense related to a different deal. The 5.8 gets charged to comp expense rather than to goodwill because the sellers will in-turn pay their earnouts or a portion of their earnout to employees that came with the deal. So that gets recorded as comp expense, not goodwill.

Moving to the corporate segment, my third point is an update on our clean-energy efforts. We’re making headway on getting three more operations that run our Chem-Mod technology giving them their permanent permits. Those operations are in the same state that has already issued permanent permits for some of our other operations which also used the Chem-Mod technology. So we believe it’s just a matter of time.

In addition, nearly a dozen other states are granting or moving closer to granting permanent permits to other utilities to use the same Chem-Mod technology. Many of these utilities were like to get planted service prior to December 31, 2011 thereby qualifying for federal tax credits. Accordingly, in the third quarter we may consider building some additional plants. If we do, we will do it just like we did in 2009. We build the plants and then quickly sell off about 70% of the plants bringing our net cash in the plants down to a fairly modest amount.

So my fourth point is some modeling help for the overall corporate segment. For the second quarter we posted results right inline with what I told you at the end of the first quarter. So looking towards the third quarter, we think you should just assume a repeat of the second quarter and now I'll get you close. As for the fourth quarter again model of repeat of the second quarter but add a penny or two of profit for our clean-energy operates under the assumption we will get permanent permits for our other three plants.

Okay, my fifth and final comment relates to the financial supplement we posted on our website. Recall during the first quarter we overhauled this supplement to present both reported and adjusted numbers for the last three plus years. We believe conforming your models to follow that similar format will really help you see the true underlying comp and operating expense ratios and also other trends in seasonality of our business.

So those are my five comments. In the end it’s nice to have a good quarter. Back to you Pat.

Patrick Gallagher Jr.

Thanks Doug. Rob we are ready to open it up for questions and answers, hopefully answers.

Question-And-Answer Session

Operator

Thank you. The call is now open for questions. (Operator Instructions) Our first question is comes from the line of Adam Klauber with William Blair & Company. Please state your question.

Adam Klauber - William Blair

Two or three questions, one on organic growth, what was the growth in international versus U.S. roughly?

Doug Howell

About half came from international and half came from domestic.

Adam Klauber - William Blair

Okay. Certainly as the domestic actually did better this quarter than the last two quarters, is that right?

Doug Howell

Absolutely.

Patrick Gallagher Jr.

Yep.

Adam Klauber - William Blair

Okay, that’s great to see.

Doug Howell

Domestically, we are in positive territory.

Patrick Gallagher Jr.

Yes.

Adam Klauber - William Blair

That’s great. And the key parameters that schedule – you weigh out was very helpful, Doug. What’s the timing of the profitability will it take a while for it to ramp up next year or particularly because first half is pretty big for your framework, will the margin be pretty high from the [get-to-go]?

Doug Howell

While it is skewed more in the first of the year, it won’t distort the margin that much compared to the whole year, Adam. So there is a little bit more towards the first part of the year but not, not – it won’t really move the needle that much. In terms of the profitability, we laid out the innovation cost for the next three years or two and half years and we think by ‘13, when we put these two operations together, we think both the operations together could be approaching kind of a combined brokerage operation margins in total. So we think there is further opportunity in ’14 versus these numbers here.

Adam Klauber - William Blair

Okay. And can you give us some detail where are the cost cuts coming from?

Doug Howell

Adam, this is a deal where we are really pleased with the people. There is more opportunity. If you really look at the comp and operating margins and if you compare it to our operations, comp is pretty well inline, operating show some opportunities. So most of the synergy savings will come from reducing operating cost and will come from additional London market commission, the compensation lines will probably hold in there pretty tight.

Operator

Thank you. Our next question is coming from Tate Anderson of Citigroup. Please state your question.

Tate Anderson - Citigroup

Good morning. I just had a quick question around organic growth, it was positive in the quarter but was kind of offset by some margin compression. Can you just help me understand the available leverage you guys have to kind of fold margins going forward and what we saw – why we saw a compression in the quarter?

Doug Howell

First and foremost, when you look at the operating margin on three of 13 the adjusted EBITDAC margin, second quarter channel was 26%, adjusted EBITDAC margin second quarter ‘11 is 25.4. Just the margin dilution caused by the Heath deal would cause 40 basis points of that differential. So when you look at 25.4, you understand that 40 basis points of that comes from – its lower because of the Heath acquisition because of the nature of their margin, that gets you to 25.8 and there is a handful of other little small items that eroded the other 20 basis point. But overall even with the Heath dilution, year-to-date we are actually up 10 basis points in margin in the brokerage segment.

Tate Anderson - Citigroup

Okay, great. And there is a second question on the supplemental and contingents, can you just kind of help us understand the drivers of each and just where we might see some loss revenue as we are seeing some of the underwriters experienced some of operability pieces here?

Doug Howell

If you look at page 2 of 13 and there we showed, we actually, we continue to grow our supplemental. We think that the carriers are interested in doing now with us and so we are using that. On the contingent, we are starting to see some of our contingents, especially in the wholesaling business contract a little bit as loss ratios move up. Most of our wholesaling business is loss ratio driven, so you can see a pull back. We are down about a 1.8 million in the quarter, year-to-date we are down about 3 million.

The lion share of our contingent commissions are behind this for the year at this point, so we might have a little pullback in the third quarter and four quarter, but nothing that meaningful that we can see right now.

Patrick Gallagher Jr.

But Tate, this is Pat, there is a natural getting the anger and you are right to be thinking about this when underwriters results start to fade these numbers will begin to change.

Operator

Thank you. Our next question is coming from the line of Sarah Dewitt with Barclays Capital. Please go ahead with your question.

Sarah Dewitt - Barclays Capital

I want to follow up about your comments on the pricing environment. Can you talk about what your view is on the sustainability of rate improvements? Given that they are still a lot of excess capacity and particularly if we don’t have an active parking season this year?

Patrick Gallagher Jr.

Yeah. I think we’re all recognize there is good capacity out there but I think that what you have got is the CEOs of some insurance companies that I talk to often really do understand that there’s a point in the cycle that they have got to start to hold the line. They’ve got good information systems, these are smart people, they know where they making money, where they are not making money and they are doing just exactly that trying to hold the line.

Now, as I said in my comments the simple fact is if you got a good account with a good clean loss ratio record and one that is out shopping they are going to see reduction. This is not going to be as great a reduction as has been in the last few years. And I have seen this before where markets gets spotty. It’s not unusual to see line of coverage have a spike in terms of this hard market, I think you’re going to see that with catastrophe property. There is no doubt about it’s going up, large schedules that are exposed to that stuff are going to pay more money and we are seeing that right now. So its one of these places where I think the market is in kind of in a spot where underwriters do know what they have got to do. Yup, there is an excess amount of capital. It’s going to chase premium that does put pressure on rates to go down and we are seeing that, But I would say that the rate of rate decrease has slowed considerably from what it was just a year ago.

Sarah Dewitt - Barclays Capital

Okay. Great. That’s helpful. And then can you talk a little bit about what you are seeing in terms of the acquisition pipeline and how big do you think you plan to get in international.

Patrick Gallagher Jr.

I mean right now the international operations are one of our fastest growing and I think in the beginning we are seeing opportunities that we didn’t before we built the platform. So being part of the Heath thing is so exciting. The more we get more team mates to joins us it is going to be a great franchise but it will allow us in the U.K. to exactly do in what we did in 25 years in United States. We are already seeing teams of people and operations in the U.K. and they are talking to us and are planning to come aboard. So bolt on acquisitions in U.K. can now become a better strategy in the retail side with the Heath platform. Two third of the premiums in the world is outside the United States and we have been trading in that community for literally 40 to 50 years and know a ton of people out there. And just like in the United States many of these organization’s brokers outside the US are run by baby boomers and overtime families and individuals will seek to take some equity and some money off the table. They also are seeing a growing brand in Gallagher, Gallagher is a recognized international player. So I think they will see us grow. Now, can international outstrip the US. You asked about the merger acquisition pipeline. It’s absolutely stronger than it’s ever been. We have hundreds of organizations that we are talking to. The merger and acquisition process is very much of a long-term sale cycle. We talked to people for years and they get warm to the idea and they come aboard. It is not like we open up a discussion in September and close the deal on October and that doesn’t happen very often. But when you look at the broker’s world there is 30000 plus agents and brokers that we’ve identified actually, [Hales] and Associates have identified in United States alone. And most of these are run and owned as I said by baby boomers and the opportunity for us on the acquisition front it’s just never been greater.

Operator

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

Mark Hughes - SunTrust

Thank you. On the risk management business very good organic growth, sustainable. Is that were there some specific upticks in business or contract wins that you’re going to get a first read at some point here to make that a little tougher.

Doug Howell

Mark, I think that if you look at the bottom of page 3 of 13, we intentionally break out adjusting fees related to international disasters and that relates to, mostly to the New Zealand earthquake situation. We believe that’s going to be around for ’11 and ’12. I think it will be pretty well done by the end of 2012. That’s why we’ve broken out last quarter and that’s what we’re going to do it going forward here. So that number is a great organic growth but I think it will be something the team has to grow over by the time they get to ‘13.

Mark Hughes - SunTrust

We’ll worry about that then. On the claims frequent…?

Doug Howell

We’re worried about that now.

Mark Hughes - SunTrust

Yeah, I understand. And then finally the claims frequency in the risk management, the underlying workers comp claims frequency and I’m thinking here in the US, any comments there?

Patrick Gallagher Jr.

We’ve seen about 2% increase in our claim activity through the second quarter, which relates interesting enough directly I believe to the economy.

Operator

Thank you. Our next question coming from Meyer Shields of Stifel Nicolaus. Please go ahead.

Meyer Shields - Stifel Nicolaus

Let me follow up on that last question if I can. Are starting to see companies retain more were getting -- how these some about where compensation rates are starting to turn upward a bit, affecting [inaudible] yet?

Patrick Gallagher Jr.

Not that we’ve seen yet. When rates go up in workers compensation, it will over time push more people into the alternative market and we will benefit from that, but there's no rush to the alternative market right now.

Meyer Shields - Stifel Nicolaus

Okay. With regard to contingence, you had fairly recently got back into the contingency, are there any contracts that have to be, or this, I am sorry let me ask this differently, is there any opportunity for new contingence that don't exist this year to be paid next year.

Patrick Gallagher Jr.

No.

Meyer Shields - Stifel Nicolaus

Okay, so you are at full run rate.

Patrick Gallagher Jr.

Yup.

Meyer Shields - Stifel Nicolaus

And lastly talk a little bit about whether we are seeing any signs, really signs whatever of specialty risks moving back from specialty markets.

Patrick Gallagher Jr.

I would say no to that, I would say that the market is still soft to the extent our wholesalers are doing a good job on what would typically be an ENS business, there's still probably some drag back to the standard markets from ENS, but its slowed.

Meyer Shields - Stifel Nicolaus

Okay. And I can do one more, can you talk a little bit about incentive competition in the brokerage business being down. Is there any such competition in the second half of 2010 that we should adjust for.

Doug Howell

No, here's a thing, when you really stack it up and when you look at our incentive compensations down a couple of million bucks compared to the same quarter last year on approaching a half a billion dollars of payroll as it rolls up, there's nothing unique in that. I don't see it as being something that's going to be different in the second half of last year. If I look at it in the second quarter of last year, we did pretty well, so incentive compensation was up a little bit more relative to this quarter but its not been unusual in that, it just happens by the time you add it up to be a couple of million bucks.

Operator

Thank you. Our next question is comes from the line of Alex Pitchard of Trimaran Fund Management. Please state your question.

Alex Pitchard - Trimaran Fund Management

Just first a financial question. I wanted to understand the trends in business insurance expenses. I noticed they were a bit of a headwind in the brokerage business, a bit of tailwind in the Gallagher Bassett business?

Doug Howell

Yeah, you know the quarter, we did block a couple of million dollars related to resolving, it is not a disagreement, a difference of opinion between us the client and our markets.

J. Patrick Gallagher Jr.

You know, I think the thing there is, every once in while, you are stuck in a spot where you just better step up and do the right thing for the client.

Alex Pitchard - Trimaran Fund Management

Okay. So, some of that sort of a one off in the quarter.

J. Patrick Gallagher Jr.

It was.

Alex Pitchard - Trimaran Fund Management

And then secondly, I just wanted to get some detail around the organic growth trends you are seeing in the brokerage business. Specifically, what you are seeing in domestic PNC retail versus wholesale versus employee benefits.

Doug Howell

I think what you have to look at is the trend, all of them are improving. I think that you would add at that and so as a result, what I am particularly pleased at if you just look at our broad-based retail PNC brokers that have been fighting eight years of soft market and three years or almost four years now of economic downturn. You are really seeing that starting to march forward and Pat said, they were doing a little bit better, our new business, we are doing a little bit better on loss business. Rate isn’t hurting us quite as much, it is still negative overall across the US retail platform. But it is just nice, steady improvement that’s reversing trend that we saw going negative really from starting about 2004. So, I think it’s just improving trends across all fronts.

J. Patrick Gallagher Jr.

And we are not seeing a large number of full-time employee growth in any of our businesses out there. I would say that we are seeing more stabilization in our clients businesses. And as I’ve said all along, we are a lagging indicator, we are going to get healthy when our clients get healthy and they are stabilizing.

Alex Pitchard - Trimaran Fund Management

I just want to go back to business insurance questions. Can you quantify how much was sort of a one-off in the quarter?

Doug Howell

I think that and compared quarter-over-quarter last year, you need to think about $2 million.

Alex Pitchard - Trimaran Fund Management

Yes, thank you.

Doug Howell

Remember, anytime you have these types of things, you got to give them result and they hit at different times and we are going to have these things from time to time.

Operator

Thank you. Our next question is coming from the line of Dan Farrell of Sterne, Agee & Leach. Please state your question.

Dan Farrell - Sterne, Agee & Leach

Just a question on the clean-energy ventures, you mentioned potentially making some additional investments in new plants, can you comment on what potential cash flows in those additional plants could be if, if you decide to make those investments, are they going to do the small ones that is three to four ones in place that are small, some others that are coming on the larger. Just trying to get a sense of what the potential benefits could be?

Doug Howell

I am not at all prepared to discuss what the benefits could be at all because I don’t have any idea about the demand for the plant, but we are talking between one and ten type plant. This isn’t like 50 or a 100 new plant and for us to build a plant regardless of whether they are going to build in big location or a small location, for us to go through that first phase before the utilities and the monetizers take down, it cost a $1 million to a $1.2 million a plant something like that. So we are not talking about huge amounts of cash going out and frankly I don’t know but I can just, there just has been a change in the last 60 days, that is saying that there is substantial demand for our Chem-Mod technology and if we have to build some plants to get them up in running, they can use Chem-Mods and then we will look at that.

Dan Farrell - Sterne, Agee & Leach

Okay. Then, and then just a numbers question on free cash at the end of the quarter, it was a bit higher than I would have thought given the amount of acquisition activity that you had. Can you comment on any seasonality that might have been coming through or is what we are always looking at normal cash flow and then also within that 263, how much of that is cash that you could use today for acquisitions if you wanted to?

Doug Howell

Spread around the world, we think there’s probably $75 million of free cash in our balance sheet right now that could be used for acquisition. That number is probably going to grow a little bit as we grow internationally, but I don’t want to bring the money back to the US and pay the additional tax they’ve garnered here. We will probably let it sit there.

So if we can deals in those jurisdictions where we have the free cash, then we will. Otherwise that we may have some growing in our free cash, you know our free cash balances around the world. But those opportunities will arise, we have some free cash flow in the UK and we obviously use that.

Operator

Thank you. Our next question is from the line of Brian Durupio with [Field] Capital Management.

Unidentified Analyst

Okay. Doug following up on that last question regarding where your cash is, thinking about your international expansion, what happens to your segment tax rates going forward? Could we expect them to trend down?

Doug Howell

Well, I think that like in the UK the tax rate is 27 going to 26% for there, but we got bad tax over there and you got other things. And the bad tax doesn’t hit the tax rate line, it goes through more the operating expense line, but you still pay tax there, so it’s not like it’s any cheaper. Yeah, you could have our tax rates moving a little bit lower in the brokerage segment as we, as we increase our international expansion, Heath will bring it down a little bit, but we are still primarily a domestic company.

Unidentified Analyst

Got you. And Pat for you and looking at the number of acquisitions that you have done and obviously the dollar amount to and all the employees that you have taken on, what’s your bandwidth to do sort of similar amount of acquisitions that you did the last year’s second half and this year’s second half, does that happen to actually slow down a little bit?

Patrick Gallagher Jr.

It’s a great question, let me answer that in a little bit length way but if you go back a number of years and you look at our acquisition activity, it was primarily driven by our P/C retail operation here in United States and that was one team of people, they were out talking to folks all the time and trying to bring about acquisitions.

If you step back now and look at where we are today, we have our P/C retail operation in Unites States with that acquisition team doing very good work, we’ve got a wholesale MGA business in United States which is doing acquisitions and has got a separate team and doing great work. We have our employee benefits consulting operation that we have built out with acquisitions over the years and they have a very good pipeline and a very good team of people doing acquisitions.

Now for the first time starting last year Gallagher Bassett, our risk management segment has proved that there are opportunities out there to bring others aboard and to consolidate them and have them work well. And our international activity is far more robust. So if you really look back a decade we have expanded our bandwidth by a factor of five times and each of those teams are out constantly looking for the right private firms to join the company and I can’t give you an idea of the number we are going to do or when we are going to close them, because it really is a long cycle sales process.

I can tell you that the activity we have in that area is great and if you take the Heath deal out Brian, I think you see that we’re kind of inline with what we have been doing in the past, then you would have eight deals and it wouldn’t be 200 million, it would be 158 million less, and now I think that opportunities like Heath will come our way.

Remember Heath represents about 8% of our overall corporate revenues now. It’s not a huge deal once you take a look at how the size of Gallagher today versus what we were just a few short years ago. So I think the bandwidth has increased. The opportunities have also increased; I’ve been saying over and over for years that the baby boomers are going to have to do something and we’re seeing a lot of more activity in that regard in particular here in the U.S.

We are seeing people that are you know 59, 60, 62 get new appoint where they’ve got to realize their investment in their life’s work. So I am very excited about what we said, as I said before you know you’ve got 36 or 30,000 plus of these in U.S. thousands more outside the U.S. and essentially there is five strategic players that the public players competing for, we don’t have pipelines that are incredibly robust.

Unidentified Analyst

Got you. And I may have missed it in the press release, so I apologize if I did, but did you guys use more cash in the M&A activity this quarter than you used to have?

Doug Howell

Yeah, Brian, I mean the entire Heath deal was done 100% of the cash.

Unidentified Analyst

Okay. Is that something you see doing more of? I know you have a traditional mix, but with great flow?

Doug Howell

We’re okay. We tried to target 25% cash, 75% stock reserve. If our cash flow is there we will bring that number down closer to 50-50.

Unidentified Analyst

Got you. And then a final question and this is sort of older-term but, Doug, what’s the end game with Chem-Mod?

Doug Howell

Chem-Mod is a tremendous product. We think that it’s got great opportunity, strategy right now is to penetrate those utilities that are using section or they want to build plants by the end of the year using Section 45 and then we’ll have our plants in place to demonstrate mercury emission control. The Mercury Emission Control Law will go into effect, that’s currently drafted in 2014. So we think it produces opportunity, but we will have to sit down and do a strategic alternatives review of what Chem-Mod, what we really want to do with Chem-Mod here after the first year. But our surge right now is to deliver Chem-Mod technology to as many utilities that can put the plants in place by the end of this year and then next spring we will do a strategic alternatives review on it.

Operator

Thank you. (Operator Instructions) Our next question is from the line of Bob Glasspiegel with Langen McAlenney. Please state your question.

Bob Glasspiegel - Langen McAlenney

On the risk management segment if we could dig a little deeper, I heard your commentary and your EBITDA numbers are very impressive yet the GAAP earnings are still way below where they were two to three years ago, when do the GAAP earnings sort of catch up to your enthusiasm?

Doug Howell

As soon as we can get them there Bob.

Bob Glasspiegel - Langen McAlenney

Right. So what's – it does sound like, am I right that you were more off beat about that segment than you've been in your commentary?

Patrick Gallagher Jr.

Yeah, I think that's fair Bob, I will tell you why. I mean when you, the headwinds that GB has brought over the last few years are related in large part to claim counts and claims are rising. As our clients businesses begin to falter and you had the recession when you go from three shifts to two shifts, you know you never like to see people get hurt, but there will be fewer claims to manage and that we went through that at a time when the recession was very difficult.

We had also had a couple of situations in previous years, we had some very nice bumps, some very nice wins that had a big impact. But I think what you've got now in both businesses is a pretty good stabilization of the client base. Interesting developments in that space too by the way make me more bullish. I mean, if you take a look at the number of competitors there were just a year ago, and now the consolidation that’s occurring. There is far fewer competitors that can actually take on a large self-insured account and adjust claims for them across the United States. There is even fewer if you want to add the U.K., Australia and Canada to that mix. And, GB is growing to a size now. Well there are many markets out there that we do more claim work than they do. And so the expertise there, the ability to customize for the clients, the expected competition is consolidating. It’s just I think a long-term, a very positive view. It’s a business we said we liked for many, many years.

Bob Glasspiegel - Langen McAlenney

Okay, softer question if I might. You talked about culture being you know, important in a real age and clearly someone who followed the company for a long time, I appreciate the asset that you have there, but can you talk about international expansion. I mean, years ago, I think I remember you saying you are only looking in places to speak English and I understand the distinction on your reinsurance sort of mixed up where it was scaled more than culture that got you off track in that, but the state street go with other languages better now or how does the Chicago culture go internationally, broadly are we still talking English only or be more.

Patrick Gallagher Jr.

No, I think we changed that this year. Bob again we are very cautious in our acquisition activity, everywhere in the world. Outside the United States, we typically want to trade with somebody for an extensive period of time. Many of these are family businesses. They want to know the Gallaghers. They want to know where we are all about. They trade with us and a number of the instances the acquisitions we have done had actually secured a good trading book in the London market. We are very happy to take a smaller equity piece where everybody gets comfortable with each other and with the exception of Heath, most of our acquisitions outside the U.K. and the United States have been relatively small. So, you will remember that we did an acquisition in Australia of SBA, out of Perth. We took a 35% or 40% equity position. We all agreed that we would go, we worked together for three or four years to see how that was working and decide if we wanted to go to a 100%. We liked those folks and they worked with us so well, we went to a 100% much quicker than that. Great opportunity there for some young people to take over the operation, we have broaden that firm now into Sydney and again we will be looking at more bolt-on acquisitions in Australia. We opened with a very small shop. They were pleased with in Brazil. As you know we took a small position also in Singapore. So, I would say that we are willing to venture beyond English speaking countries but we are also always cautious and want to know the people we are trading with.

Bob Glasspiegel - Langen McAlenney

What are that English speaking countries that you are not in are the most attractive?

Patrick Gallagher Jr.

Central and South America.

Bob Glasspiegel - Langen McAlenney

But broader Asia is in emphasis?

Patrick Gallagher Jr.

Not right now.

Operator

Our next question is coming from Scott Heleniak, RBC Capital market. Please state your question.

Scott Heleniak - RBC Capital Market

Not to beat the international [pothole] too much but, you guys mentioned the 25% of the mix by the end of the year being international. Where do you see that headed, three to five years and now obviously you’ve come a long way, some of your peers are more like right around 50%. Could you see getting that high or where you see that?

Patrick Gallagher Jr.

I think it, we would be glad if it was about a third of our business. Right now it’s a 25% but our acquisition activity in the United States is ramped up very nicely. I don’t think international will outstrip that.

Scott Heleniak - RBC Capital Market

Okay. And then also in M&A we noticed that just overall not really to you guys but overall M&A activity in the brokerage space dropped off in June and July. So, based on your comments its sounds like, do you think that's temporary and do you think there is any change in seller's appetites just because of -- obviously we are seeing better pricing domestically over the past two or three months. Is there any change in seller's mentality because of more favorable trends. People waiting a little bit to see what happens?

Patrick Gallagher Jr.

No, we don’t.

Scott Heleniak - RBC Capital Market

Okay. And then finally on Heath Lambert, can you give what percent of the business there is be new business? I don't have that.

Doug Howell

I don't have it right here in front of me. But let me see if I can find it, go to another question and maybe we can come back to it while I'm looking for it. ¬

Scott Heleniak - RBC Capital Market

Just broadly speaking on Heath Lambert, I wonder if you can touch on the -- just on the reception that you have had from clients and retention of accounts, any kind of disruption, everything as planned?

Patrick Gallagher Jr.

Scott, there, I'm really, really proud of the work our people did in terms of the early start to integration. And we are, I mean the reception is beyond what we expected. First of all, you’ve got a company that was a large publicly traded company just a decade ago that has gone through an awful lot of change in that decade to becoming a private company, exiting most of their wholesale work, becoming very focused on the U.K. retail. Maintaining a very good brand in the market during that whole period of time and yet being in a position where couldn't do acquisitions, didn't have the cash flow for that, didn't have a lot of money to invest in almost anything and the management team I think did a good job of building that company, actually I should say shrinking that company to a point where it was successful.

So I think the hearts and minds of the Heath people really are embracing the Gallagher culture, the fact that sales and marketing organization this may not play well with the investment community but you know they like the fact that they are working for a broker that’s run by brokers and I think what we’re seeing are tremendous number of teams that are sticking their toe in the water to see that Gallagher would be interested in having them join as a bolt-on acquisition or a team coming over.

Clients have been, again I have been very, very – have felt very good about the way the clients react. I can tell you from doing acquisitions all these years, clients will react inline with the tone of the merged organization’s leadership. We have never done an acquisition and had full scale revolt by clients saying we don’t like that. If their current executive teams are happy and feel that it gives them more opportunity to serve the client, the clients are generally very positive embracing and we are seeing that in England as well.

Doug Howell

The 35% of it is fee.

Operator

Thank you. Our next question is from the line of Richard Mortell, Piper Jaffray. Please state your question.

Richard Mortell - Piper Jaffray

Can you talk about the risk management segment and it looks like you are running into a 15% margin. How significant is the reinvestment there in terms of the margin. Is that 2% to 3%?

Doug Howell

I don’t know if I fully I understand what you meant by the reinvestment but let me see if I can answer the question. We tried to target that business to run 15 points of EBIDTA and whatever they need to reinvest in the business they do within the 15 points; its not a real heavy CapEx business for us its -- so there isn’t a lot of reinvestment if that’s what you’re talking about.

Richard Mortell - Piper Jaffray

Yeah, I was just referring to systems and may be office build out so…

Doug Howell

You know really it’s typically we spend basically what we depreciated.

Richard Mortell - Piper Jaffray

Okay. And then the fees from the natural disasters, it looks like it was up a little bit from last quarter, how volatile that can be over the next quarter and for the quarter that plays out?

Doug Howell

Well it’s pretty steady, probably for the next four quarters, and I think you’ll start seeing a ramping down in the quarters five to eight following.

Operator

Thank you. Our next question is from Ken Billingsley with BGB Securities. Please state your questions.

Ken Billingsley - BGB Securities

Just wanted to just ask you a couple of questions, one on the corporate side. The two operations that you currently own 90% of – I know you said that there’s more operating side for those two, so what’s the cost or what’s the I guess the annual cost of owning that if there’s no actual physical locations for it?

Doug Howell

Our CapEx, in that we spent 1.9 million on those two machines so that’s offsetting on that, in the warehouse and there’s nothing new to carry the cost until we get in the place.

Ken Billingsley - BGB Securities

Got it. So – but it’s 1.9 for both machines?

Doug Howell

Yeah.

Ken Billingsley - BGB Securities

Okay. And another question I had on the letter of credit or line of credit, you are down about 35 million, was that just on Heath Lambert?

Doug Howell

It’s more – our first quarter as you know is our seasonally lowest quarter and going in to the line has something to do with doing the Heath Lambert deal and it’s also just our first quarter is in the lowest cash quarter we have; I expect it to be out of that here hopefully by the end of even this month.

Operator

Thank you. Our next question is a follow-up from the line of Meyer Shields of Stifel Nicolaus.

Meyer Shields - Stifel Nicolaus

This is I think a big picture question that is like difficult to answer but if we start to see rates go up by 1% is there a rule of thumb in terms of how much on the basis points will fall to Gallagher's bottom line?

Doug Howell

Remember if we have organic growth of negative one to positive two, holding margins would be good work for the franchises in light of inflationary pressures and new opportunities to do things. So, if you get one point of rate positive rate, we see rates still being down three percent. We will see what the CIB comes out with here later this week but overall, if you get an incremental four percent that, if you assume that all translates to the bottom line and you take our three points of organic right now and add four more to it and you get seven percent of organic growth. You can get a good piece of that falling to the bottom line. Remember, we pay approximately 25% to a third of our revenues to our producers.

There are additional back office costs that do come along with increased volumes but if it's just rate and it doesn't produce a lot of additional work, it can be pretty high geared revenue that comes to us. Okay, great. Thank you..

Operator

Thank you. We have time for one more question. Our last question is coming from the line of Mark Hughes of SunTrust Robinson as a follow-up . Please state your question.

Mark Hughes - SunTrust

Thank you very much. Any commentary on the employee business, organic growth, trends there and any thoughts about the impact of health care reform on that business going forward?

Patrick Gallagher Jr.

We've said all along that we were not in favor of that law. We still believe that the laws is a nightmare for commercial America but we were not in favor of that law. We still believe that the law is a nightmare for commercial America. But we are the beneficiary of the difficulty in understanding the law. What we are seeing is tremendous amount of questions from our clients relative to what the impact of this law is going to be. And these are complicated calculations and they are very complicated answers over many years and as you know, the regs themselves are not written yet but many of stuff in the law are already changing. So, you see McDonalds and others come up and want their many benefits plans to be approved even though in the original law they weren’t. So the point is it’s a moving target. Organic growth in our benefits operation is exceeding our property casually and also operations United States I believe a large part of that is driven by the fact that clients now recognize they need a stronger and bigger player to help them navigate through the labyrinth of that law. So, we are picking up new business there. We are just seeing a stronger organic growth there and I think it is driven by that law.

Operator

Thank you. Mr. Gallagher, I would like to turn the call back to you for closing comments.

Patrick Gallagher Jr.

Yeah, thank you, Rob. Again, everybody thanks for being with us on the call today. We appreciate it. Six months in, I am pretty happy with where we stand. Our adjusted Brokerage revenue is up 13%, EBITDA in the Brokerage side is up 14%. Risk management, adjusted revenue up 19, adjusted EBITDA up 14%. First six months, we’ve done 13 acquisitions, brought in over $200 million of annualized total revenue. Organic growth in the quarter I think, speaks volume for the sales culture. I feel good going into the second half of the year. Our board as you know, reaffirmed our $0.33 quarterly dividend last week. And I believe 2011 is just shaping up to be an outstanding year. Thanks for being with us this morning.

Operator

This does concludes today’s conference call. You may disconnect your lines at this time.

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