Description

Arthur J Gallagher a long-term compounding model with upside from its long-term outperformance in the U.S. SME broking market.  Shares trade at $245 at EV/2024E EBITDA of 16.0x, which reflects fair value for a business of this quality and is in-line with its longer-term historical valuation. 5-year returns are anchored around ~10% IRR / 1.5x MOIC assuming no multiple expansion, a 7.5% EBITDA growth rate (in line with organic revenue growth rates and historical margins in 30-32% EBITDA range) and reflecting its 1% dividend yield.  Upside could be in the ~15% IRR / 2.0x MOIC area assuming 10% EBITDA growth (higher organic growth from continued execution and margin expansion) and multiple expansion to 17.5x.

Market backdrop

Insurance brokers continue to benefit from a firm P&C pricing cycle, a unique inflationary environment, and a tight labor market.  The inflation protected nature of insurance premium pass-throughs combined with the non-discretionary nature of property, casualty and benefits insurance purchases provide downside protection.  Investor focus is likely to remain on the sustainability of favorable organic growth trends into 2024. Stability of the growth trend is likely to increase with incremental visibility into favorable 1H24 P&C market dynamics, with potential offsets from uncertain macro narratives (i.e. rates and others).

In terms of exposure growth, inflation and employment levels will continue to drive the narrative. Consensus U.S. nominal GDP expectations stand at 5.8% due primarily to stronger than expected employment and persistent inflation. A stable 3.7% unemployment rate is predicted to continue through the end of the year. P&C pricing may modestly decelerate in 2H23 from strong absolute levels, these aforementioned factors drive an above-average outlook for brokerage organic growth. The P&C pricing trajectory sits between an improved insurer ROE outlook due to rising fixed income yields/improved underwriting profitability, and insurer caution around the inflationary environment and increased weather events. Thus, pricing is likely to remain steady overall, though specific insurers with less property exposure could be pressured slightly.

P&C renewal premium change (includes pricing and exposure growth) may decelerate in businesses less exposed to property markets (where prices have been increased less in recent quarters). The magnitude of deceleration is mixed, however, primarily due to business mix differences, varying degrees of economic headwinds, and exposure to transactional business that falls outside of the typical renewal cycle. Mid to high single digit organic growth in retail P&C globally is likely. High-single-digit to low-double-digit premium growth in Reinsurance brokerage. Employee benefits is expected to be flat or a modest tailwind to overall organic growth as strong demand and rising medical costs are partially offset by solid yet decelerating wage increases and employment growth. Modestly decelerating organic growth in E&S markets is likely as stamping office submission flow has remained resilient despite a lower property weighting and CA premiums inflected positively (+16% 3Q23 vs -5% in 2Q23). Overall, pricing and exposures remain healthy and continue to provide for above-average organic growth levels compared to long-term averages.

Overall commercial pricing increases to remain fairly steady, though company reported pricing indices could be pressured by the lower weighting to Property business QoQ, driving some deceleration. Insurers continue to weigh higher investment yields and improved underwriting over the past several years against ongoing inflationary pressures on claim costs. Property pricing is exhibiting the strongest pricing increases as increased frequency and severity of weather events and higher Property-CAT reinsurance pricing filters into primary pricing models; a trend we think could continue well into 2024. On the other end of the spectrum, pressure on workers’ compensation and public D&O pricing remains a headwind, with incrementally more D&O business in 2H vs 1H. Additionally, while cyber pricing increases remain solidly positive in the high-single-digits according to MarketScout, the rate of increases have decelerated to +9% from +13%/+23% in 2Q23/3Q22. The MarketScout/Ivans is showing a greater than typical divergence, with Ivans pointing to modest broad-based acceleration in P&C pricing, while MarketScout data points to fairly broad-based pricing deceleration in the quarter. Notably, MarketScout’s over commercial pricing index fell to 3.5% in July (before improving to 4.1% in Aug), which represents the first sub 4% data point since July 2019. Our overall view for modest pricing deceleration hasn’t changed much however, and we consider pricing indices alongside more bullish pricing comments from industry participants. Given uncertainty regarding the trajectory of inflation in addition to its longer-term impact on reserves, we would expect insurers to communicate their intent to continuing seeking pricing increases at relatively similar levels. We note that at its September investor meeting, AJG management expected similar P&C market conditions continuing over the course of 2023 and into 2024.

The primary near term macro focus surrounds the health and trajectory of brokers’ more discretionary consulting businesses, which are typically the first to show economic pressure in more difficult environments - and as a result could see deceleration in these areas. Additionally, continued higher fiduciary investment income as expectations for short term yields in 2024/2025 continue to incrementally rise (30-60bps in 2Q23). Internationally exposed brokers are likely to guide and report modestly more FX pressure than previously communicated due to dollar strengthening in FY 2023, though a favorable YoY impact to revenues from dollar weakening YoY still exists.

A key question at the operating model level is can operating leverage outweigh rising variable costs? Expectations for margin expansion should be optimistic; Brokers face rising variable costs YoY from more normalized levels of T&E (though less than 1H23) and from wage growth. However, the majority of brokers’ cost structure is not increasing in-line with headline inflation, with producer compensation largely tied to revenues. Operating leverage, fiduciary investment income, and expense efficiencies will support margins going forward

Gallagher background

Arthur J. Gallagher & Co. and its subsidiaries, are engaged in providing insurance brokerage, reinsurance brokerage, consulting, and third-party property/casualty claims settlement and administration services to businesses and organizations around the world.  Gallagher delivers comprehensively structured insurance, insurance and risk management solutions, superior claim outcomes and comprehensive consulting services to our clients, which are generally medium-sized accounts.  Gallagher is the fourth-largest insurance broker in the world behind AON, MMC and WTW. AJG has three reportable segments: brokerage, risk management and corporate, which contributed approximately 85%, 14% and 1%, respectively, to 2022YE revenues.  We generate approximately 65% of our revenues from the combined brokerage and risk management segments in the U.S., with the remaining 35% generated internationally, primarily in the U.K., Australia, Canada and New Zealand. 

AJG vs. peers on key operating metrics:

Key thesis points

AJG is uniquely positioned to benefit from the core trends of inflation, P&C pricing, and rising interest rates that are tailwinds to P&C brokerage in the current environment. The US middle-market orientation of AJG's P&C brokerage business allows for a higher weighting to commissions versus large-account peers (captures inflation + pricing), while also benefiting from higher P&C pricing and lower recessionary risk compared to small-account focused brokers. The company's recent acquisition of legacy Willis Re bolsters AJG as a top-three broker in reinsurance - a business line where climate change, market disruption, and poor insurer returns will drive significant growth near-term and over the next several years. Additionally, AJG's brokerage-heavy business and unique premium financing business allows AJG to be the greatest beneficiary to higher interest rates amongst its peer group. These tailwinds will allow AJG to perform better in a potential downturn versus the last two recessions, and the company has significant ability to buyback shares opportunistically, if the capital is not spent on value-creating roll-up M&A. AJG is a defensive company that has historically outgrown its competition and can expand margins meaningfully throughout a potential recession.

Gallagher has historically, and is expected to continue to deliver among the strongest organic growth in the industry: Amongst retail oriented brokers, AJG will likely to continue to post the highest organic growth over the coming years, driven by a US P&C oriented business mix that is heavily weighted towards commissions, which allows AJG to benefit from pricing and inflation. Additionally, AJG's acquisition of legacy Willis Re in late 2021 brings new reinsurance capabilities (reinsurance now 10% of the firm) at an opportune time for exposure to the product, and which allows AJG to better service clients from a holistic perspective. The company added nearly 7,000 employees (+21% YoY) in 2021, including ~2,100 from the acquisition of legacy Willis Re. AJG's smaller Third Party claims Administration business (TPA), will continue to benefit from claim counts approaching pre-pandemic levels. Over the medium and longer term, AJG has an underappreciated opportunity to win additional business from large insurers looking to outsource their claims administration.

In a recessionary environment, AJG screens as best positioned amongst retail brokers. AJG's HR/Career Consulting business (5% of revenues) as the highest risk, and the TPA business (15%) is also a higher risk. Typically, the firm's E&S exposed businesses (12% of revenues) would be higher risk but coming expectations for the impact of pricing and inflation and stamping volumes trends have shown this business to be resilient. As such, AJG growing EBITDA mid-single-digits even in a -4% Real GDP growth scenario in 2023, despite modestly negative organic growth is plausible.

3Q 2023 results support the thesis with a broad based beat, including 10.5% organic growth.

Pricing vs. inflation impact

Margin expansion will continue from operating leverage and investment income: Brokerage/RM combined adj. EBITDA margin expansion of 40bps/90bps/50bps through 2024 is on track, on top of cumulative margin expansion of 490bps from 2019 through 2021. In 2022, the above-average operating leverage created from 9%+ organic growth is being partially offset by the return of T&E ($25mn/30bps), opportunistic investments in marketing, advertising, consulting, professional fees and technology (total $35mn/40bps), and likely some wage pressure. In 2023/2024, fiduciary investment income will be the primary driver of margin expansion on average over those two years - but operating leverage could be an equal contributor over this time. Additional margin upside could be drawn from the firms overseas premium financing operations which are also levered to higher rates, and which we estimate will contribute $80mn+ of investment income p.a. in 2023+.

Management sees 2023E and beyond potentially returning to an environment similar to pre-pandemic, where 3-4% organic growth creates core margin expansion and 5%+ organic growth creates 50bps or more of core of operating leverage. Ultimately, should management be able to achieve 5-7% organic growth estimates in 2024/25, management will be in the driver's seat with respect to allowing operating leverage fall to the bottom line or investing in future growth

3Q 2023 results support the thesis with a broad based beat, including EBITDA margin expansion of 67bps to 30.8%.

Margin performance since 2008

FCF deployed through Roll-up acquisition strategy has years of runway + potential shift to more buybacks: AJG will continue to be the most acquisitive retail broker in the peer group as the company continues to deploy free cash flow through its roll-up acquisition strategy, generally targeting firms generating less than $10mn of annualized revenues. $2bn of M&A p.a. (run-rate 2022/23) can be fully funded without equity issuance. The company typically acquires 80 firms per year, representing about $700 million of revenues. The recent increase in interest rates may help ease elevated acquisition multiples of recent years by dampening interest from PE buyers. The company expects to pay between 9x - 10x EBITDA for acquisitions this year, and while this is roughly 1x higher than pre-pandemic, this still represents a 36% discount to AJG's 3-year average multiple of 15x, creating a potential arbitrage opportunity.

Nonetheless, as AJG's EBITDA grows we expect there to come a time when the company deploys capital through a hybrid strategy of M&A and buybacks. Additionally, should the company's stock price fall to levels where buybacks make more sense in recession.

Valuation and simple model

Risks

• Slowing organic growth as a result of a hiring slowdown or producer retention issues
• Cost savings/margin expansion execution would drive EBITDA results lower than expected
• M&A FCF deployment slows or multiples rise
• Macro issues in insurance broker business related to unemployment, rate shocks and other recessionary-related headwinds

Mitigants

• AJG management team is among best in business, delivering repeatedly on double-digit growth, margin expansion (15 p.p. since 2008) and thoughtfully diversifying the business to be a global leader, focused on the attractive medium account segment
• Current macro setup favorable relative to other recessionary periods for insurance intermediaries
• Only 3 down years of broker premium growth (2008-2010) in last 70 years

Catalyst

- Continued performance on organic growth, margin expansion, FCF deployment into M&A

- Favorable conditions for brokers persisting in a higher than average inflationary/rate environment