Arthur J. Gallagher

We think Gallagher's second-quarter results were solid overall, with organic growth ticking up slightly and strong underlying margin improvement.

Why it matters: Overall organic revenue grew 6% year over year, a modest pickup from the 5% rate reported in the previous quarter. Year-over-year organic growth in insurance brokerage commissions and fees was 4%, in line with the previous quarter and with results we've seen from peers of late. We're encouraged to see the company maintaining its organic growth amid a weakening insurance pricing market, but question how long this will hold. Adjusted margins (excluding the impact of higher cash balances related to the AssuredPartners deal last year) improved 110 basis points year over year, an improvement from the previous quarter and a level above our long-term expectations.

The bottom line: We will maintain our $250 per share fair value estimate for the narrow-moat company and see the shares as about fairly valued. With most commercial insurance carriers still generating very strong returns, we continue to believe that weaker insurance pricing could become a protracted headwind for the insurance brokers. Gallagher completed six brokerage acquisitions during the quarter, but the run rate of acquired revenue this year is tracking well below last year's results. While some slowdown might be expected as the company absorbs the large AssuredPartners deal, we'd like to see the company return to a stronger level of roll-up activity as soon as possible, as we believe Gallagher has shown it can create value with these deals.

We are increasing our fair value estimate for Gallagher to $253 per share from $250, due to time value since our last update. Our fair value estimate equates to 19.2 times our adjusted 2026 earnings per share estimate.

We project overall revenue to grow at an 10% compound annual rate over the next five years. Our near-term estimates are boosted by the AssuredPartners acquisition. We model ongoing small tuck-in brokerage acquisitions at a level roughly in line with the company’s historical rate. However, our projections do not include any large acquisitions beyond AssuredPartners. Excluding acquisitions, we project brokerage revenue to grow at a 4% organic rate over our projection period.

We believe the company can achieve underlying margin improvement due to solid organic growth and leveraging costs through its roll-up strategy. We assume adjusted EBITDA margins improve at an average annual rate of about 25 basis points over our five-year projection period.

We use a cost of equity of 7.7% and a weighted average cost of capital of 7.2% in our valuation.

Gallagher's narrow Morningstar Economic Moat Rating derives from switching costs and a relatively sticky client base.

Gallagher’s insurance brokerage segment, which accounts for about 90% of revenue, is the primary driver of our moat rating. Gallagher acts as an advisor to its corporate clients and works to identify their insurance needs. It then helps clients manage their risk by negotiating and placing their insurance risk with insurance carriers. Insurance brokers are uniquely positioned to serve a necessary risk-management function. Brokers can search the insurance market more efficiently and effectively than individual buyers, helping clients compare insurers' skills, financial strengths, and reputation. During the matching process, brokers also help insurers solve problems related to asymmetric information, such as adverse selection and moral hazard. The complexity of these services creates switching costs, as we believe the value of changing providers is not clear to customers, and there is perceived value for clients in continuing to work with a broker that has experience in managing their risk. Compared with peers like Aon and Marsh McLennan, Gallagher is more focused on serving middle-market clients, which may have limited resources and are therefore more reliant on their insurance broker. Gallagher estimates its client retention rate is 90%-95%.

Gallagher’s other segment is risk management, which focuses on providing third-party claims adjustment services for companies that choose to self-insure. The client base for this business is typically larger, and margins for this segment are lower than for the brokerage segment. However, we think this business also enjoys some switching costs and is not dilutive to the narrow moat around Gallagher’s primary brokerage business.

Gallagher traditionally has been relatively acquisitive. While it does complete some large mergers and acquisition deals like its peers, it is differentiated in its ongoing strategy to buy small insurance brokerage operations. In our view, Gallagher uses this type of acquisition almost as a hiring tool, in order to bring in brokers that have a proven record of success and could benefit from the resources a larger operation can provide. Deals typically involve an earnout provision in order to keep targets incentivized once under Gallagher’s roof. The company’s historical performance suggests this is a value-creative way to produce growth. Return on invested capital has held at a low double-digit level averaging 11% over the past five years and has improved modestly over time. We think these results support our narrow moat rating for the company.

The stability of its brokerage operations makes Gallagher a relatively steady producer of free cash flow.

With the insurance brokerage industry still fragmented, Gallagher should have plenty of opportunities to roll up smaller brokers.

Compared with larger peers, Gallagher remains relatively focused on insurance brokerage, which we view as the most attractive aspect of its business.

Gallagher's established position in a relatively mature market lowers its long-term organic growth prospects.

Most of Gallagher’s free cash flow is devoted to acquisitions, which leaves the company’s long-term success tied to continually finding good M&A opportunities.

The Gallagher family maintains a strong presence on the management team, but its ownership interest is very limited.