Description

Insperity (NSP) and its Professional Employer Organization (PEO) peers, TNET and BBSI, have been written up several times on VIC. For a more detailed background on the PEO industry please refer to those prior posts. VIC member ril1212 wrote a very timely short thesis on Insperity in June 2019 which I believe has played out to a large extent setting up an attractive entry point in the stock.

Quick Industry Background

Insperity primarily acts as a human resources outsourcing company for small and medium- sized businesses (SMBs). NSP is technically known as a Professional Employer Organization, or a “PEO” in industry parlance. A PEO acts as a co-employer for its client’s employees (referred to as Worksite Employees or “WSEs”) and is considered the employer-of-record in the eyes of the IRS. The primary benefit of this co-employment structure is that by combining all client employees into a single legal entity, NSP can provide lower cost benefits (including health insurance and workers’ compensation). The negotiating power of overseeing ~240,000 WSEs makes NSP one of the largest employers in the country and results in lower insurance premiums than SMBs can find on their own.  Besides administering benefit plans, NSP’s bundled solution includes important HR functions such as payroll processing, time and attendance, retirement plan administration, government compliance, risk management, recruiting and training. These services are provided via cloud-based software applications as well as on-site and telephonic support from NSP’s business performance advisors. In return for these services, NSP charges each client an upfront fee per WSE on a monthly basis.

Using a PEO provides significant value to employers. In addition to lowering benefit costs, PEOs reduce administrative costs, primarily due to employers requiring fewer in-house HR professionals. A PEO also provides SMB owners more time to focus on revenue generating activities rather than the ~30% average time a non-PEO owner might spend on employee-related activities. Using a PEO is estimated to generate ~$1,775 of annual cost savings per worksite employee (a nearly 30% ROI on the cost of utilizing a PEO).  There are other tangible benefits resulting from the services provided by PEOs. Small businesses using a PEO have been shown to grow 7-9% faster than other SMBs, demonstrate 10-14% lower employee turnover, and are 50% less likely to go out of business than similar peers. According to NAPEO, WSEs under a PEO relationship grew at an 8.3% CAGR from 2008-2017. This is remarkable growth when viewed in the context of 1.4% annual employment growth over this time frame.

Co-employment regulations differ on a state-by-state basis and until 2014 there was no federal recognition of PEOs for the purpose of wages and payroll taxes. As a result, the legality of the co-employment structure with the IRS was ambiguous. It also created friction due to the tax consequences of joining a PEO mid-year. In addition, a PEO sale can be difficult to close because it involves replacing approximately seven other HR-related functions at once with a comprehensive offering as well as getting business owners comfortable with the idea of co-employment. Taken together, these factors materially slowed new client adoption. In December 2014, a federal law allowed the IRS to begin recognizing PEOs as “certified” PEOs (CPEOs) and eased the barriers to signing up new clients. This was a watershed moment for the PEO industry and should continue to support faster industry adoption. Once a new client is won, they are not prone to switch service providers. The average client uses NSP for approximately 7 years (retention has recently averaged ~85%). I view this as an attractive retention rate for the SMB space where clients often go out of business, merge, or grow too large to continue using a PEO.

Today, PEO penetration is still low with approximately 4 million employees served through a co-employment model. This represents between 10-12% of the 35-40 million U.S. employees that could be a good fit for the PEO model. To further demonstrate how much whitespace remains, another large PEO CFO has suggested they find themselves in competitive bidding situations only about one-third of the time when pitching to new clients. Today, the Top 5 PEOs control ~45% of industry WSEs with the remainder covered by a fragmented landscape of ~900 PEOs. NSP is the fourth largest PEO and commands 6% market share (and only 1% of its addressable market). Insperity has consistently outgrown the overall PEO industry with a 12.5% WSE CAGR the last 5 years.

Why the Opportunity Exists

• Elevated Medical Claims during 2019 – While insurance activities are not the primary profit center for Insperity, because NSP self-insures the majority of its WSE’s medical claims, it is exposed to both favorable and adverse underwriting outcomes. Insperity had the misfortune of experiencing elevated medical claims starting in Q2 2019 which resulted in lowered earnings estimates and a ~50% drawdown from its 52-week high. Over the last decade, NSP has only realized adverse claims expenses in five quarters, three of which occurred in 2019. Historically after this happens, claims costs return to their normal expected ranges in subsequent quarters. Due to the unprecedented length of time these adverse claims have remained elevated, I spoke with several former executives and competitors to reaffirm NSP’s reputation as a conservative underwriter was still intact. These calls, in addition to discussions with management about what’s causing the spike in claims, gives me enough comfort to believe 2019 was an anomaly. Furthermore, health insurance is a short tail policy so these issues should not permanently carry over into subsequent periods. Insperity adjusts pricing each year for individual clients based on their specific claims experience as well as overall healthcare cost inflation trends. This means given enough time, Insperity will reprice all its clients to levels that achieve historical profitability targets. If gross margins (a proxy for underwriting normalization) return to the 10-year average of 17.3% EPS would benefit by close to $0.30.
• Poor Guidance Communication by Management
• I believe most investors expected Insperity management to provide 2020 guidance on their most recent call that included medical claims returning to normal levels. Expectations were high as shares had already rebounded 30% from the Q2 earnings miss with little interim news. Instead, Management decided to take a more conservative approach and assumed jumbo medical claims would remain the same in 2020 or increase on trend with WSE growth. They didn’t say that medical claims would remain elevated, just that they have no proof to confidently say they will normalize (but did state severity had been trending lower from a high point in Q2’19 but at a slower pace than usual after periods with elevate claims). While there is always the risk medical claims don’t normalize, I think management is trying to manage expectations and is setting up for a series of beat and raise quarters as the year progresses. This cadence of starting guidance off low matches how they’ve managed expectations in prior years.
• Management also guided to an elevated tax rate of 28% which further confused investors (up from a depressed 21% rate in 2019 due to SBC deductions). This should revert to a ~25% tax rate from 2021 onwards. They also did not include any share repurchases in their EPS guidance even though they retired ~3% of shares during 2019 and have ample FCF to continue doing so.
• Finally, Management did not assume any workers comp accrual release benefits in their guidance (which have occurred every year since they moved to their current carrier in 2003). These accrual releases are virtually 100% margin profits so excluding them is quite meaningful. Simply using the average annual amount of accrual benefit released per WSE over the last 5-10 years suggests EPS could end up around 9% higher. Even if the accrual release is small it should still aid EPS by a few percent.

The Combined Impact on 2020 Earnings

Combining the impact of the four factors discussed above (medical claims normalization, workers’ compensation accrual releases, share repurchases, and tax normalization) could result in 2020 EPS coming in 15-25% higher than the mid-point of guidance. If this happens I’d expect the multiple to re-rate to its historical long term averages in the 19-22x Fwd. P/E range.

As a side-note, TriNet management were more optimistic with their 2020 medical claims guidance (net insurance margin) provided just a few days after Insperity earnings. As a result, they were rewarded with a 20%+ rise in their stock price (they also announced a large incremental share repurchase program and said their shares were undervalued compared to peers). I believe if Insperity would have taken a similar approach the share price reaction post earnings would not have been so severe. I take some consolation in the fact NSP can now repurchase shares at lower prices (and they announced another 1m share repurchase authorization last week).

 Historical Financial Summary

Demonstrated Operating Leverage

Approximately 40-45% of NSP’s operating costs are fixed or semi-variable, which should continue to drive incremental margins above current levels as NSP continues to grow. Leverageable expenses include administrative costs, infrastructure costs, and increased footprint/real-estate utilization. Semi-variable expenses include sales functions, service centers, and technology costs. While NSP is a services business, this operating leverage can be clearly seen as operating expense per WSE has declined by an average of 3.0% a year over the last 5 years.

Management has suggested low teens revenue growth can translate into 15-20% EBITDA growth.  From 2014-2019 they exceeded these targets with EBITDA growing at a 24% CAGR compared to 13% annualized revenue growth. This translates into a 10% EBITDA CAGR per WSE over the same period (with the entirety of this operating leverage driven by Opex savings as gross profit margins actually declined by 10bps due to the elevated medical claims in 2019).

I agree with management’s assessment that there is room for additional operating leverage as margins are still more than 500bps below larger peers like ADP and TNET that earn ~40% EBITDA/GP margins. Part of this margin difference is explained by NSP’s historically higher growth than peers. New clients are less profitable in the year they are on-boarded which temporarily depresses margins. Sales reps I have talked to suggest it can take up to 18 months after a new client is signed up to reach breakeven. I think this dynamic would also provide a path to closing the margin gap with peers if WSE growth were to slow. Furthermore, Insperity is growing its geographic presence more rapidly than peers by opening new branches. These new branches take time to mature and as utilization increases, profitability follows. Management is incentivized to continue improving the unit economics of the company as 30% of annual bonuses are tied to achieving operating expense targets and gross profit contribution per WSE.

Forecast & Expected Returns

I think Insperity can return to its historical pace of WSE growth and profitability as 2020 progresses. Through 2025 I believe WSEs can grow at a 10.6% pace (compared to 12.5% over the last 5 years). Gross Profits can grow slightly faster than this at a 12.7% CAGR due to modest pricing (~1%/year) and a return to normal medical claims experience. Continued operating expense leverage can drive 14% EBITDA CAGR and EPS growth of ~19% (driven by a 4% annual share count shrink). I anticipate leverage only increasing modestly to 1.2x in my exit year.

Capital Structure Optimization

After a 2015 activist campaign by Starboard Value, capital allocation has improved dramatically at Insperity. NSP has always focused on a purely organic growth strategy where internal reinvestment has generated high double-digit to even triple-digit ROICs. Rather than spending any excess cash flow on M&A, the remainder of capital has been returned to shareholders (M&A has been an Achilles heel for some PEOs such as TriNet who have experienced elevated insurance claims, client churn, or salesforce attrition post acquisition). From the start of 2015 to present, NSP has returned nearly 150% of FCF to shareholders through a mixture of buybacks, regular dividends, and special dividends. This includes a Dutch auction tender for over 12% of outstanding shares in January 2016 (at only $23.75 per share). Even with this rapid return of capital, NSP maintains a nearly unleveraged capital structure of 0.6x ND/EBITDA (up from -0.8x at the end of 2014).

There is additional upside if Insperity continues to lower its cost of capital with incremental leverage. I don’t anticipate a rapid leveraging event but Management has suggested they could continue to slowly take leverage higher. In the event management (or a PE buyer) were to further increase leverage I think 25-30% IRRs are achievable over a 5 year period. TriNet easily supported ND/EBITDA ratios in the 3-4x range for several years after it first IPO’ed. Before coming public, TriNet’s leverage was even higher than this (backed by General Atlantic) and other PEO’s are using high leverage to consolidate the fragmented PEO landscape. The below sensitivities outline what returns would look like assuming a more aggressive pace of share repurchases each year culminating with a more optimized capital structure in five years.

Potential Sale Candidate

A more ambiguous catalyst is my belief the CEO may seek to sell Insperity when he retires. Paul Sarvadi is now in his mid-sixties and has run Insperity for nearly 35 years. His lieutenant since 1989, Richard Rawson, retired in 2018 (but still remains on the BOD). It appears Sarvadi may be in the process of literally trying to write the narrative around his legacy. Sarvadi recently published a biography and leadership advice book titled Take Care of Your People and has significantly increased his media appearances. More importantly, Insperity disclosed a meaningful change to its severance plan on January 3rd 2020. This change was disclosed on a Friday night (a great time to bury material disclosures) and created new benefits for senior executives in the event they were terminated after the sale of the company. I believe this would trigger an additional $6 million payout to Sarvadi as well as several million dollars to each of the 12 other named executives. I believe this change has significant signal value since Sarvadi has operated without this benefit for over 20 years as a public company CEO.

Furthermore, former senior executives of the two largest payroll processing companies were added to the Insperity board during the Starboard campaign in 2016 (the former Co-President of ADP and former CFO of Paychex). Both ADP and Paychex have recently prioritized the growth of their PEO divisions and may have interest in scaling more rapidly through M&A. In 2018, Paychex acquired the largest private PEO, Oasis Outsourcing, for $1.2 billion so it has demonstrated an appetite for larger deals. The former ADP executive, Tim Clifford, chairs the compensation committee at NSP, so he was clearly instrumental in the newly sweetened severance plans (Clifford also joined the technology, healthcare, and business services focused PE firm Welsh Carson as an operating partner in the last 6 months). While I ascribe a low probability to an immediate sale, the severance disclosure certainly got my attention. In the meantime, I believe speculation around a transaction by a strategic buyer or private equity will help support a premium valuation. I also believe an activist such as Starboard could return if operating performance continues to languish for several more quarters.

Risks

• Elevated insurance claims do not return to historical levels
• Parodic quarters with elevated benefit claims (volatility)
• Negative workers compensation accrual charges (this has never happened since at least 2003 when Insperity moved its coverage to Chubb)
• Economic recession (clients go out business, declines in hiring, and slowed wage growth)
• Slowed WSE growth due increased customer churn, a recession, or ineffective sales
• Inability to attract and retain additional sales reps (BPAs)
• Increasing competition from other PEOs and software based human capital management solutions (such as Dayforce or Paycom Software).
• A more exogenous risk, the passage of Medicare-for-All under a potential Democratic government, could change the relative appeal of a bundled HR solution. In the unlikely event this were to occur, I believe demand for private health coverage will remain, especially as a way for employers to differentiate themselves in a competitive labor market.
• Regulatory changes to PEO legality/structure
• Adverse contract renegotiation with primary medical insurance carrier (United Healthcare) in 2022 or Workers’ Comp carrier (Chubb)

Disclaimer: The information contained herein reflects the views of the author as of the date of publication. These views are subject to change without notice at any time subsequent to the date of issue. The author has an economic interest in the price movement of the securities discussed in this presentation, but the author’s economic interest is subject to change without notice. All information provided in this presentation is for informational purposes only and should not be deemed as investment advice or a recommendation to purchase or sell any specific security. While the information presented herein is believed to be reliable, no representation or warranty is made concerning the accuracy of any data presented. In addition, there can be no guarantee that any projection, forecast or opinion in this presentation will be realized. All trade names, trademarks, service marks, and logos herein are the property of their respective owners who retain all proprietary rights over their use. This presentation is confidential and may not be reproduced without prior written permission from the author.

Catalyst

• Earnings beats and guidance increases as 2020 progresses

• Activist steps in again – agitates for change or evaluating strategic alternatives

• Potential sale of company in next few years (Strategic or PE)