AJG - Arthur J. Gallagher: Expecting A Strong FY23

2023-03-22 03:24:48 ET

Summary

• Management believes that the current favorable P&C conditions will persist throughout the year.
• Brokerage is expected to grow organically by 7% to 9% in 2023, with risk management growing 10%, and management has maintained margin guidance.
• Given the company's solid management, bright FY23 outlook, and reasonable valuation, I am giving AJG stock a buy recommendation.

Investment thesis

During its Investor day in March 2023, Arthur J. Gallagher ( AJG ) expressed optimism about the company's prospects and the industry as a whole. U.S. Retail Property & Casualty [P&C] Renewal Premiums were up 8% in the first two months of 1Q23. Positively, management believes that the current favorable P&C conditions will persist throughout the year. Brokerage is expected to grow organically by 7% to 9% in 2023, with risk management growing 10%, and management has maintained margin guidance. My take is that AJG is in a good position to achieve significant organic growth due to recent business investments and its involvement in property and casualty insurance brokerage, including reinsurance. What is important for AJG shareholders to note is that in spite of the economy's uncertainty, management is more positive about its forecasts than it was at the end of 2022. Following this investor day , I think the market will have a more optimistic view of FY23's growth and margin outlook, which will help to prop up the valuation for the year (at least until 4Q23, when management will begin to provide FY24 guidance). We could also see an influx of investors (i.e., the quants and pod shops) rushing into AJG stock to ride the strong momentum and also to "hide" in AJG given a lot other industries are getting negatively impacted by the macro weakness. All in all, with a clear earnings growth outlook for this year, I think AJG has a strong thesis and is a buy.

Industry update

Property and casualty insurance premiums are stable and largely in line with those of 2022. On the other hand, insurance renewal premiums globally have increased by more than 8%. Large increases have been seen in the cost of P&C reinsurance, while increases in the cost of casualty reinsurance ranges from the single digits to the double digits. That said, the increased cost has not dampened the market for reinsurance. In fact, the lower-layer frequency claims are a major concern for P&C reinsurers, so they are increasing the attachment points.

There will still be pressure from the reinsurance market on the primary market in 2023, but management is less worried about a recession than it was in the third quarter of last year. My belief is that Inflation is somewhat beneficial to AJG as it is unlikely that primary rates will decrease due to social inflation, increased property claim frequency, replacement cost inflation, and higher reinsurance costs. In addition, the tight labor market is driving the need for consulting services from clients in the employee benefits segment, which I believe will result in favorable new business and retention trends for AJG in this area.

Brokerage still doing fine

Management has reiterated 7%-9% organic growth guidance for the brokerage segment for FY23, while guiding to 8-9% organic growth in 1Q23. Even with inflation and steady P&C pricing in the background—as evidenced by the 11%/9% renewal premium change in NZ/UK, respectively—the organic growth environment is robust, and I am heartened by management's guidance that this trend will continue throughout the year. On the other hand, not dampening the positive mood, my understanding is that 1Q23 is a particularly busy quarter for employee benefits, and that results in this segment are expected to be weaker than P&C, where management guided organic growth of 6%. While this looks "bad", I believe it might lead to AJG showing the market it can accelerate growth - which will likely lead to more optimism around the stock. Specifically, given this 1Q23 dynamic, I anticipate a sequential acceleration in organic growth in 2Q23 as the P&C business will be a larger mix of the revenue base and is projected to remain strong through FY23. In my view, when considering the broader context, I think that the projected organic growth is backed by a robust inflationary backdrop, which I believe will continue to significantly influence growth. Additionally, the increase in loss costs will encourage careful underwriting and the continuation of property and casualty pricing increases. This, of course, also brings the risk of a deflationary environment. Given the price increase has a huge benefit on margins (high incremental margin), when this benefit goes away, AJG would likely be hit right in the nose. As such, while things are going well, I would caution investors to stay alert and be ready to size down their positions in AJG.

Margin guidance for FY23 has not changed; they still anticipate margin expansion of >50bps. The guide seems reasonable, taking into account the fact that previously dormant costs, such as travel and entertainment, have resumed operations following the end of the covid period, which will have a short-term negative effect on margin. However, management has commented that this is only a temporary setback and that things should return to normal through this year. Combining the midpoint of the 8% organic growth guide with the anticipated margin expansion suggests earnings growth in the high single digits to low teens is possible. However, I feel it's important to remind investors that the need for investment has increased in light of the Buck acquisition (which has lower margin than the overall Brokerage segment) and other reinvestments. Management has stated that annual reinvestment spending in the range of $300–$400 million is necessary to fuel future growth and enhance the customer experience. Management, in my opinion, is making smart investments at the right time by taking advantage of the favorable operating climate to fortify the company's operations and extend its growth potential. In layman's terms: I like how management invests during the best of times so that it can withstand the tide better during the trough periods (likely FY24/1H25).

Risk management segment update

The first two months of 1Q23 have been very successful for AJG's third-party claim administration business. Because of this, management is now forecasting organic growth of about 12% for 1Q23, up from the previous projection of 10%. Since we are getting close to the end of 1Q23, the updated projections are reasonable. Looking forward, management anticipates growth to persist across all client segments in 2023, in particular by new customer dealings with carrier large clients and public entities. I would also point out that the rise in the need for TPA solutions as a result of inflationary pressures on carriers and businesses works in favor for major TPAs like AJG as they have scale. In sum, I anticipate these factors will remain primary growth drivers throughout FY23.

Conclusion

In conclusion, the outlook for AJG is positive, and I believe that AJG is making smart investments at the right time, taking advantage of the favorable operating climate and reinvesting into the business to improve operations and extend its growth potential. The combination of a strong management team, clear FY23 outlook, decent valuation (20x forward earnings which is in-line with historical average) makes this a buy rating, in my opinion.

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