Description

We are long Barrett Business Services (BBSI) and see the potential for the shares to almost double to a price of $72 over the next 12 months.  At $35.81 you are buying a business growing 20%+ in an industry with a multi-year secular growth story for 9x 2016 EPS.  BBSI was posted by ruby55 last fall and I suggest you read both the write up and the Q&A, since the posting there have been a number of significant events that warrant a fresh write up.

Brief business description:

• BBSI is a Professional Employer Organization (PEO) which helps small to mid-sized businesses outsource their human resources functionality, it makes sense for a business to use a PEO for two main reasons—complexity of health insurance/payroll obligations in the new world of ObamaCare, and cost (BBSI charges on average $1000/employee vs having a full time HR position at $50-60k salary)

• The most important functionalities they provide for their clients are payroll, health insurance (using outside providers), and workers compensation insurance (provided internally, much more on this later)

• The company’s historic sweet spot was blue collar centric firms, however, this has shifted in recent years towards a more even blue/grey collar mix, typically their clients have between 15-50 employees and they skew heavily towards the West coast

Why you want to own it:

• BBSI has a multiyear penetration runway ahead of it, they work with 3300 clients now which represents less than 2% penetration in their Western focused markets, it will be a mid teens grower for the foreseeable future

• While the large reserve charge in 2014 was unfortunate it “cleared the decks” for workers comp risk going forward and all of the relevant metrics point towards the reserve being more than adequate presently

• The PEO business is very attractive when its humming along, revenue visibility is high, incremental margins are strong and free cash flow should approximate net income

• Currently the stock trades at 9x 2016 EPS and 10x 2016 FCF, the direct comps NSP/TNET trade at 23x/17x EPS and the larger players like ADP/PAYX get 20-23x

• Business is great, Q1 revenue was +24% and their net client adds were a new record high at 229

• Insiders have been buying stock in the open market over the past few weeks at higher prices, there was also a slew of buying last year after their took the reserve charge

Why the opportunity exists:

• Cleary after tanking from a high of $100 down to $20 in 2014 something must have went very wrong, and it did, they took an $80m reserve charge to more accurately reflect their workers compensation liability which represented approximately 25% of their market cap at the time, this stemmed particularly from policies written under the old CEO and founder who passed away in 2011

• After announcing this charge there were three main fears that, while valid in the cloud of uncertainty, have since been resolved:

  • That they would need to tap the equity markets to satisfy the roughly $48m of after tax capital needed to plug the hole created by the reserve—this was taken off the table with a $40m revolver from Wells Fargo and the free cash flow they will generate in 2015

  • Their contract with their reinsurer, ACE, was set to expire in January 2015 and it was possible it would not be renewed if ACE was uncomfortable underwriting BBSI’s paper after they learned about the charge--the deal was renewed on schedule (and ACE has direct access to all the policies underwritten since 2013, so this speaks to their comfort level around the more recent reserving levels)

  • Policies written after 2011-12 were not covered by the charge—mgmt has explicitly stated it covered all policies to date

• The market’s perception is that BBSI is a different, dirtier, business than its comp group that is only able to gain customers by offering underpriced workers comp insurance, we believe the facts don’t support this point of view

  • BBSI makes approximately $388 of EBIT per worksite employee (WSE) per year, this compares with NSP at $375/WSE and TNET at $545/WSE—if they were actually just selling a commodity you would think the profitability per WSE would be orders of magnitude lower than the competitors

  • Retention rates are >90% and, despite their competitors best efforts, they only lost a handful of customers during the reserve charge turmoil of 2014—if you only rely on a business for insurance and you think their ability to provide it is in jeopardy you run for the door and ask questions later—their average customer remains with the company for 4-5 years

  • Currently only 30% of BBSI’s customers only use the more basic services included in their “Tier 1” platform

• In their most recent 10-Q it was disclosed that the SEC was conducting an investigation into their workers compensation accrual procedure

  • This is a tougher one to handicap as its always difficult to predict the outcome or nature of an SEC investigation and they are under no obligation to disclose when the investigation has concluded

  • Its important to remember that the majority of the claims that caused the reserve charge were underwritten and reserved for before the current management was in place

  • We think the worst case scenario here is a restatement from 2014 backwards, and while this would cause volatility in the stock, it wouldn’t change the forward economics of the business

How can we know the worker’s comp issues are over?

• The first data point to look at is the credit that Q1 prior period claims came back at, management has stated they believe the $80m charge was conservative but this shows that the strengthening for claims they settled in Q1 had been too aggressive

• Regardless of whether its BBSI or NSP or TNET, these claims have a long tail and can be unpredictable.  Comparing each book is also difficult given the different nature of the workers comp being underwritten.  That being said you can compare some simple metrics and see how the three players stack up

• We consider two main metrics to be important when considering the situation.  Firstly, are you reserving at an adequate rate for current WSEs being underwritten, and secondly, is your total accrual appropriate as a multiple of current/prior year paid claims?  Below are the metrics for each company for the FY 2014

• The key takeaways to us are as follows:

  • BBSI’s metrics are right on top of NSP but both are below TNET

  • This makes sense as TNET caters more to white collar/white shoe business than the other two, this can be seen in the low levels of payout per WSE (its hard to break your neck on the way to the coffee machine!)—NSP’s client mix is more inline with BBSI

  • You can no longer make the argument that BBSI is an outlier in terms of its reserve levels, as this becomes more clear to the market the valuation should gravitate towards its peers

Valuation

• Our EPS estimates for 2015/2016/2017 are $3.40/$4.10/$4.80

• The stock is cheap on both an absolute basis at 9x and a relative basis vs other PEO/Staffing comps trading at 17x-25x

• The company could easily be acquired by a larger competitor, NSP has attracted Starboard’s attention and we could see them coming in with a bid

• We expect the company to generate $30M in free cash flow next year, once the line of credit is paid off they will use the cash to aggressively buy back stock

• We think a 15x multiple is reasonable giving a fair value of $61 today and $72 in 12 months

   

Catalyst

-Q2 earnings call

-Q2 10-Q showing further prior year reserve credits

-commentary on SEC resolution