Description

Arthur J. Gallagher & Co. (AJG) is poised for an outstanding 2023.   Industry conditions are favorable, and AJG likely should lead the group with both organic growth and acquired revenue.

The insurance brokerage industry is concentrated 60% among the top four players, and AJG has a 10% share.   A stable competitive environment and mostly recurring revenue make for a high-quality industry.  Founded in 1927, Gallagher has preserved its founding culture even at a $40B market cap.  Members of the family active in management own $350 million of the stock.

Gallagher is 87% brokerage and 13% risk management, with a presence in 130 countries.  Brokerage is 63% domestic and 37% international. Brokerage revenues are 52% property & casualty, 21% employee benefits, 15% wholesale, and 12% reinsurance.  Risk management is mostly helping Fortune 1000 companies and carriers reduce workers’ compensation losses.

The U.S. insurance brokerage industry is firmly in a hard market and Gallagher is especially advantaged.  AJG 2023 revenue will reset meaningfully higher given it is 78% commission based. 

Insurance policies are set to broadly cost 10%+ more in 2023, a big boost to AJG commissions.  Renewal pricing is the sum of exposure changes and rate increases. 

Insurance exposures were largely flat pre-Covid and decreased during the pandemic.   Starting in 2022 exposures increased at a mid-single-digit rate, driven by price inflation.  2023 exposure will also be driven higher by inflation (even as inflation wanes, as a disproportionate portion of the year’s renewals occurred in January).  Gallagher’s January renewals were up more than 10% in price.

Insurance rate increases, particularly in property markets, will be elevated this year.  After more than $100 billion in property losses each of the past two years, reinsurance rates have risen.   This in turn has primary property insurers citing catastrophe rate increases for 2023 in the 10% to 40% range.    Travelers recently said “….it’s hard to characterize this pricing environment as anything other than very strong….. incredibly stable and near record levels.   The breadth of the pricing gains across our book is very strong and very consistent.”   Gallagher recently said it thinks the property market could get ‘a lot firmer’.  Willis expects between 0% and 10% price increases in the following major lines: general liability, auto, umbrella high hazard, and excess high hazard.

There is room to run, as insurance rates, only recently starting to recover from a major soft market and period of stagnation, have not kept up with inflation.

Historically, accretive M&A has been a revenue driver for Gallagher.  However, during the past several years, private equity (PE) paid up and pushed aside publicly traded brokers.  PE has aggressively rolled up the brokerage industry, doing 2/3rd of all the 800+ deals in 2022. 

M&A conditions have now changed in favor of Gallagher.  Leverage ratios for each of the insurance brokers backed by private equity have reached 7x to 8x (vs. AJG at 2.1x).   Four private equity-backed brokers issued debt last Fall at an interest rate cost of around 10% (SOFR + 3.75% to 5.75%).  This now higher cost of capital means acquisitions no longer make sense for private equity.

It may prove propitious that Gallagher was less active acquiring the past few years.   Multiples paid for acquisitions with $10 million plus in revenue increased from below 12x EBITDA in 2019 & years prior to 14x EBITDA the past two years.  Acquisition multiples should recede in 2023 given higher borrowing costs and less PE competition.  Gallagher expects to pay 10x to 11x forward adjusted EBITDA for acquisitions this year.  Gallagher on its January call said, “we feel very good about our (acquisition) pipeline right now….. I think it’s going to be pretty strong in the first couple quarters of the year.”   Gallagher did four deals in January, the most of any public peer. The company has $3 billion of cash dedicated to 2023 acquisitions, including $700M for HR/EB specialist, Buck.  The remaining $2.7B should bring in ~$900 million in revenue.  Buck, AJG’s second-largest acquisition, will help make the business more digital, given its proprietary software for benefits administration.

Gallagher has delivered industry-leading organic growth through multiple insurance market cycles.  The company led peers with 9.7% organic growth in 2022 and with 11.0% growth in Q4.  Public peers have guided to mid-single-digit or better organic growth for 2023, while AJG expects 7% to 9%. 

Gallagher has continually improved efficiency and margins, using its increasing scale as leverage with carriers.

The business is inherently highly cash-generative, creating a virtuous cycle of plowing organic growth into acquisitions.  CFO has grown steadily, and CAPEX is minimal:

Gallagher trades at 21x consensus 2023 EPS, which is in line with the stock’s 10-year average P/E.  Peers, AON, Marsh & McLennan, and Brown & Brown trade at 21, 22, and 23x EPS.  

As the year progresses and Gallagher deploys its $3B in cash to acquire ~$900M in revenue while growing 9% organically, adjusted EPS may reach $10.     This above-peer growth, along with a continued uptrend in margins, argue for a top-of-peer P/E of 23 and a 20+% investment return.  If the multiple doesn’t expand, you own a high-quality business with both cyclical and secular tailwinds.

Catalyst

Organic growth in a hard insurance market and the return of acquisition-driven growth.