AJG - Arthur J. Gallagher Is Strategically Solid But Trades At A Premium

2023-10-11 15:42:08 ET

Summary

• Arthur J. Gallagher reported Q2'23 revenues of $2.44bn, a 21.52% YoY increase.
• AJG operates in the insurance brokerage and risk management sectors, with a strong presence in P&C products and employee benefits.
• The company is slightly overvalued, with a high P/E ratio and lackluster dividend returns.

Arthur J. Gallagher ( AJG ) is a Rolling Meadows, Illinois-based international insurance brokerage and risk management services firm, which operates as one of the largest insurance brokers in the world.

Through its activities, AJG has seen Q2'23 revenues approach $2.44bn- a 21.52% YoY increase- alongside a net income of $234.50mn- a 17.49% decline- and a free cash flow of -46.70mn- a 116.66% decline attributable to large decreases in operating cash flows.

Introduction

AJG principally operates across two verticals; its brokerage segment which accounts for 87% of revenues and its risk management segment, which accounts for 13% of revenues. Through its brokerage segment, AJG has become a leader in P&C products as well as employee benefits, positioning itself across the insurance supply chain, from wholesale through reinsurance brokerage. And in risk management, AJG is among the leading participants in workers comp and managed care.

With its sheer scale, AJG has become a highly diversified servicer of inelastic products, exposed to significantly lower risk than retail-facing insurers. However, the market seems to have overpriced AJG's strength from these operational levels, with the company slightly overvalued.

Thus, balancing the company's operational strength with its share price overvaluation, I rate the company a 'hold'.

Valuation & Financials

Trailing Year Performance

In the TTM period, AJG's stock- up 32.02%- has seen superior price action to both the US insurance industry, represented by the iShares U.S. Insurance ETF ( IAK )- up 12.51%- and the broader market, as represented by the S&P 500 ( SPY )- up 20.07% in the same period.

The success of AJG is a hybrid result of strong relative earnings and aggressive M&A of companies which are likely discounted due to higher interest rates, including- since Creative Capital Ideas' last Seeking Alpha article on AJG- Altman Insurance, Hartley Cylke Pacific Insurance Services, Ace Commercial Insurance Centre, Eastern Bankshares' insurance unit, Frontier Financial Services, Morgan Trevathan, & Gunn, Southern Insurance Group, Lifesure, Horn, and Wigmore Insurance Agency.

On the other hand, the rest of the insurance industry is more sensitive to risk dynamics and subsequent payouts, and more exposed to interest rate risk due to bond holdings, leading to a relative underperformance to the market.

Comparable Companies

With AJG being a leading company within the insurance brokerage space, there are a limited number of similarly sized direct competitors. As such, I sought to compare AJG to adjacent insurance businesses of similar market capitalization, since they operate on similar dynamics. This group includes but is not limited to the London, UK-based AON plc ( AON ), which provides a range of services from risk mitigation to management consulting, the fellow London, UK-based Willis Towers Watson plc ( WTW ), which provides risk management and insurance brokerage services, and Daytona Beach, Florida-based P&C insurance brokerage, Brown & Brown ( BRO ).

As demonstrated above, in the TTM period, AJG has experienced best-in-class price action, largely driven by the company's superior growth capabilities- with peerless ROE- and strong balance sheet, with the highest book value per share. However, I believe that AJG's rally has led to a multiples-based overpricing of the asset.

For instance, AJG maintains the joint-highest trailing P/E, signaling the company's relative overvaluation regarding its earnings. Additionally, AJG sustains the joint-highest forward P/E, the highest P/S, the joint-second highest P/CF, and the lowest ROA.

Furthermore, the company's dividend is lackluster, offering a 0.93% return on the highest payout ratio of the group.

Valuation

According to my discounted cash flow analysis, at its base case, the net present value of AJG is $218.42, meaning, that at its current price of $233.42, the company is overvalued by 6%.

My model, calculated over 5 years without built-in perpetual growth, assumes a discount rate of 9%, balancing a higher cost of capital with AJG's lower debt/equity and lower beta. To include the potential impact of AJG's aggressive M&A strategy, I estimated the 5Y forward average revenue growth rate to be in line with the inflated, due to macro tailwinds from COVID-19, 6.65% 5Y trailing average, but slightly lower at 6% due to rising rates.

Alpha Spread's multiples-based relative valuation supports my thesis on overvaluation, estimating a relative value of $209.68, with the stock overvalued by 10%.

Thus, averaging out my NPV and Alpha Spread's relative value, the fair value of AJG is $214.05, an ~8% overvaluation.

AJG is a Leader in Insurance Brokerage & Advisory

Central to AJG's operational success remains its diverse presence in both insurance brokerage services and risk management- both from a segmented and regional perspective. For example, the firm's insurance brokerage revenues can be divided among retail property and casualty, retail benefits, wholesale insurance packages, and reinsurance products. The latter enables both a presence along the entire insurance pipeline with diversified end clients, from individuals to companies to insurers.

This diversity extends into AJG's category specialization as well, with AJG providing services across manufacturers, service companies, nonprofits, government institutions, and so on and so forth.

AJG is thus able to effectively follow its macro organic growth strategy, applying simultaneous geographic and product and service expansion, enhancing the company's ability to cross-sell to consumers, developing expertise across industries, and entering alternative markets to improve existing products and services. This strategy has been augmented by AJG's inorganic strategy, enabling superior entry into new markets while deepening expertise within existing ones.

Wall Street Consensus

Analysts are much more optimistic about AJG's future, estimating a 1Y price target of $245.88, a 5.48% increase, which would net even more for investors given AJG's 0.93% dividend.

At the minimum projected price target, however, analysts see a 14.63% price decline to a price of $199.00.

This range in price targets illustrates analyst sentiment on how to best value the strength of AJG's operations relative to existing stock price and how that will lead into the future.

Risks & Challenges

Rising Interest Rates May Compress Product Demand

Although AJG sustains a relatively low debt/equity level and does not directly hold bonds as an insurance brokerage, many of AJG's consumers or end markets are directly impacted. For instance, reinsurance, which accounts for 13% of AJG's brokerage revenues, has insurers as the primary consumers, and with insurance portfolios hit hard by rising interest rates, the demand for discretionary reinsurance purchases may decline. Such impacts may reduce AJG's scalability and overall operating cash flows.

Poor Earnings May Have Outsized Impact

Since AJG has performed exceedingly well in the trailing twelve months, being treated as a relatively safe haven for capital preservation, a poor earnings report or downgraded guidance may have a significant impact on AJG's stock price, since the perception of AJG as a stock would change overnight. Such an event- overreaction or not- may have longer-term implications, increasing AJG's cost of capital, increasing its beta, and reducing the company's fundamental value proposition.

Conclusion

Looking forward, AJG's solid operational model will likely enable a continuation of past financial trends, though stock price growth may be limited due to the company's overvaluation.

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