Description

Barrett Business Services (BBSI) provides outsourcing of human resources functions to small and medium sized business.  BBSI is a highly profitable business with no debt and a large cash position that currently offers a compelling opportunity for investors with a multi-year time horizon.  The stock has been under pressure due to economic concerns and the current market valuation is disconnected from the value of the business.

Background

BBSI offers two broad services; Professional Employer Organization (PEO) and staffing.  Gross margin dollars are currently split about 50/50 between the two, but the trend is towards a higher mix of PEO business.  Margins are better on the PEO business, and neither business has much in the way of capital requirements.  The company has 45 branches in 10 states with the majority of the business (~75%) coming from California and Oregon.

PEO services - In a PEO arrangement, employees of BBSI’s clients are co-employed by BBSI.  Barrett assumes some or all of the HR functions including payroll, benefits, workers’ compensation coverage, and compliance and regulatory issues.  BBSI is paid about $1 thousand/employee annually.  By aggregating all of their employees, BBSI is able to use its size to keep benefit and insurance costs below what any of its clients could obtain for themselves.  This allows their clients to focus on their businesses and can reduce their payroll costs due to the savings from workers compensation and insurance.  BBSI targets clients with 20 – 200 employees and low workers compensation costs.

The PEO business is very attractive. It is characterized by high profitability, recurring revenues, high switching costs for clients, little competition, and strong growth prospects.

• BBSI generates high returns on capital.  After tax ROIC has averaged about 30% over the last three years.  Returns on incremental capital employed are even higher.  I expect BBSI to continue to generate returns above its cost of capital. 
• PEO contracts are annual with automatic renewals.  Contracts can be canceled with 30-day notice.  Switching costs are high in the PEO industry, and BBSI tends to keep business once it is won.  It is a headache for small firms to manage their own HR functions, and it can be costly to replace BBSI with multiple other HR vendors. BBSI boasts an industry best 90% retention rate. 
• Gevity HR (GVHR) and Administaff (ASF) are BBSI’s primary national competitors.  Barrett’s CEO, Bill Sherertz, believes that the market is so large and under-penetrated that it will be several years before they begin to encounter each other on a regular basis (they primarily operate in different regions).

Staffing – BBSI provides on-demand, short-term, long-term, and indefinite-term staffing services as well as comprehensive on-site management.  BBSI targets large employers with seasonal human capital fluctuations.  Examples of their clients include wineries, canneries, warehouses, distribution centers, and call centers.  BBSI’s goal is to help their clients control payroll costs with just-in-time staffing.

Strategy and Outlook

My argument that BBSI’s shares are undervalued assumes that the company’s management is smart about their allocation of the cash on the balance sheet.  I have been burned in the past by companies that had a large cash position and then wasted it on a bad acquisition.  After meeting with CEO, Bill Sherertz, I feel comfortable that the management team at Barrett Business Services will serve as good stewards of capital.  I believe that BBSI will use their cash position to aggressively buy back shares and make acquisitions when they are attractive financially and strategically.  The dividend (currently yielding ~2%) is safe and will be funded by cash flows.

Acquisitions - BBSI made three acquisitions in 2007.  They were all immediately accretive.  More importantly, they closed at an average multiple of 5x EBITDA and generated a 12 month after-tax ROI of 13%.  Management is looking primarily at deals that diversify their geographic exposure.  They are seeing some motivated sellers that just don’t want to go through an economic downturn.  In summary, the current environment is providing attractive acquisition opportunities.

Share repurchases – The board of directors recently authorized BBSI to repurchase 1 million shares.  When asked on the call how many shares remained under the current authorization, the CEO said, “Well, from my point of view, I think it’s right around 10 million shares.”  (There are currently about 11 million shares outstanding.)  The actual number was 840,000 according to the CFO.  It is worth noting that the Sherertz is the Chairman, President, and CEO and owns about 1/3 of the outstanding shares, so he probably wouldn’t have a hard time increasing the authorization if he continued to view his shares as undervalued.  Management has stated that they would be aggressive buyers at prices below $20/share.  I view this as smart capital allocation given the valuation and high ROIC.

Another sign of the value Sherertz sees in the company can be found in his opening comments to the 3Q07 call, when he stated, “…the numbers that we're putting up and the guidance are not exactly terrible numbers. So it looks like to me that if you take the cash out, we're selling at eight times earnings and if you guys want to sell it down to five times earnings maybe I will just buy the whole (expletive) thing. With that, go ahead, ask the questions.”  I asked him about this statement and he seemed genuinely interested in taking the company private if the share price declined much further.

Outlook - While the economy presents a major near-term challenge to BBSI, I believe that the company will benefit from the stability of the PEO business (which wasn’t a meaningful part of BBSI until 2003).  Management has guided to 2008 EPS being in-line with 2007.  The street is currently looking for a 3 cent decline.  The core business is declining and will be offset by the acquisitions made last year.  Excluding acquisitions, staffing revenues will be down significantly.  PEO revenues will likely be down slightly.  Revenue from new clients will be offset by lower revenues from existing clients.  (BBSI is paid per employee.  Smaller workforces mean fewer revenues.)

HR outsourcing is an early cyclical business.  Staffing revenues show the strongest growth at the beginning of a recovery.  The PEO business will also accelerate sharply when the economy recovers.  BBSI will continue to add clients throughout the downturn, taking advantage of weakness at smaller competitors.  When employment recovers, Barrett’s wider base of clients will add more employees and the business should leverage nicely.

Earnings Power - I estimate that with company’s current offices, BBSI can generate $22 million in distributable earnings (NOPAT) when the economy recovers.  This assumes:

·         $30 million in gross revenues per branch.  BBSI did $27 million in 2006.  2007’s numbers are lower ($25 mm) due to acquisitions late in the year not contributing a full year’s revenue.  Management believes the 14 CA branches can do $100mm/year up from $40-50mm currently.  Revenues at recently acquired staffing companies could grow nicely when PEO services are introduced to the newly acquired clients.

·         Gross margins of 5.5%.  BBSI did 6% as recently as 2005.  Last year gross margins were 5.28%.

·         SG&A equals 3% of sales.  There is tremendous leverage potential in their business.  SG&A was 3.23% of sales last year, down from 6.84% in 2003.

·         These assumptions imply an operating margin of 2.5%.  BBSI did 2.5% in 2005.

·         This results in normalized EPS of $1.96 and a FCF yield of about 11%.

If I am wrong on my assumptions it is probably on the conservative side.  The increasing mix of PEO business will likely result in higher operating margins than the company has seen in the past.  Also, this estimate is likely to prove very conservative as it ignores any potential acquisition activity or de novo branch openings.

Valuation

Relative valuation measure have not been this low since the company posted negative net income in 2001 and 2002 (operating cash flow was still positive in 2001 and barely negative in 2002).  It is extremely unlikely that the company will lose money in the foreseeable future.  Due to its outstanding profitability, the company has built up $64.5 million in cash and short-term investments ($5.72/share as of 12/31/07).  At the current price of $17.59/share, some of the relative valuation measures are as follows:

• P/E = 12.3 (8.2 excluding cash)
• P/CF = 11.2 (7.4 ex. cash) Capex is almost entirely used for growth.  Maintenance capex is minimal.
• EV/EBITDA = 5.1

It is hard to predict when the economy will bottom out and even harder to predict when investors will begin to look past the cyclical trough.  On normalized earnings, I believe that BBSI’s current franchise is worth $24 or about 35% higher than the current price without forecasting any growth.  (Earnings power of $22mm discounted at 11% plus cash of $64.5mm)  Acquisitions, de novo expansions, and market share gains from struggling competitors provide further upside to my target.  If you assign any value to future growth (and you should), the stock is worth considerably more than my $22 estimate.  Furthermore, the downside is somewhat limited by the cash position and aggressive share repurchases.

Risks

• Exposure to West Coast economy.  The CEO firmly believes that CA is already in a recession and has been for several months.  He mentioned the unemployment rate in CA is near 7%.  There may not be much more downside.
• In the PEO business, BBSI is exposed to workers compensation claims.  If these aren’t properly reserved for, or if claims rise, BBSI’s results could be hurt.  BBSI has a good track record for improving safety records at its clients.  Each branch has a risk manager that reports directly to the CEO.  These risk managers can cancel a contract at any time.  BBSI has a good safety history and has recently made changes to its accounting to more conservatively estimate workers comp liabilities.  This should minimize the risks of future negative surprises.

Catalyst