Description

We are short Insperity (NSP) and believe fair value for the stock is $70, or about 40% lower than today’s price.  Insperity is one of the largest PEOs (Professional Employment Organization) in the country. If you look back through VIC you’ll see that the PEO names have a history on the site (we wrote up BBSI long side back in 2015, TNET has also been pitched), the reason they get a lot of action is the market’s view of the business quality can vary pretty drastically depending on the industry conditions.  When times are good they are secular growth stories with fat margins and a vastly underpenetrated TAM, as such they can get juicy multiples. When times are tough they are actually competitive insurance businesses that cater to highly cyclical small businesses and trade at 10x (usually trough) earnings.

A brief intro to the PEO business:

• Professional Employment Organizations effectively outsource HR back office functionality for small businesses and become the employer of record for their employees.  They deal w/payroll, benefits, 401k programs, etc.

• The main benefits to the business owner are cost savings associated with HR personnel reductions and the assurance of compliance if/when employment laws change in their state of business.  In addition, since the PEOs buy insurance on behalf of their whole customer base they can get a lower price based on scale.

• Attrition is pretty high (mid-teens %) as their customers have a higher failure rate and a “success penalty” from either growing out of the scale benefits a PEO provides or being acquired.

• Employees under the umbrella are called WSEs (worksite employees).

The short thesis boils down to:

• Earnings have benefited from a multiyear expansion in insurance margins that is unlikely to improve from here (the same is true for TNET), in fact, a large portion of earnings growth in 2017 and 2018 was due to a reversal of workers comp accrual

• It’s a cyclical business, their main customers are small businesses with less than 50 employees, not only will attrition/failure increase in a downturn but workers comp insurance claims tend to pick up as well (why not file a claim if you fear you’re about to be let go….)

• NSP trades at 23x forward earnings, margins are above prior peaks, we think the cycle is getting pretty long in the tooth, the stock charts of most cyclicals paint the same picture, it’s pretty tough to justify a peak multiple off of peak margins/earnings for NSP

The insurance side of the business:

• Firstly, NSP does not clearly break out insurance margins, I would recommend looking at TNET’s financials as a proxy because they clearly break out staffing/insurance profitability separately.  You’ll get a good idea for how important insurance is to the P&L and how wildly it can swing (the margin has gone from 12% in 2012-2013 to 6% in 2014 back up to 14% this year and now makes up 35% of their EBIT).

• They offer both worker’s comp and health insurance to their customers, but both are structured differently.  Worker’s comp is funded by them up to $1m per claim at which point Chubb takes over the liability for a fee, they set up an accrual for this annually.  Health insurance on the other hand is more of a success spread business, they are paid based on the claims level of their book and it is accounted for as a pure margin fee, the healthier their WSEs the higher the fee, its less subjective than worker’s comp accounting.

• Where is gets interesting is workers comp reserve releases benefited costs by $18.8M in 2018 and $16.3M in 2017 (per the 10-k), EBIT growth was $50m and $24m, respectively.  That is a pretty big boost for an accounting reversal that could go the other way in the future if the claims/settlement environment turned unfavorable.  

• Another quick note, underwriting these clients tends to be tougher when you’re growing quickly, numerous industry contacts we’ve spoken to have said that PEO books are tough to grow faster than M-HSD without sacrificing some client/underwriting quality.  NSP has been growing mid-teens for three years in a row (a function of them growing their salesforce).

The cycle:

• While its anyone’s guess when we get the sense recession our sense would be we’re closer to the end than the beginning

• On their last call NSP agreed that at the margin their core clients were seeing a bit of deceleration:

• Mark Marcon

I'm wondering if you can talk a little bit about what you're seeing with regards to the employee growth within your client base. You mentioned it's a little bit slower than it was a year ago. How should we think about that? What are you seeing in terms of overtime and sales commission?

• Paul J Sarvadi, 'Management Director Chairman Chief Executive Officer'

Sure. We went ahead and budgeted for the year for a little bit lower contribution from in terms of growth from within the existing client base. And we saw that come to fruition in the quarter, but it's not much.

• RHI, the temp staffer, on their call said businesses slowed sequentially throughout the first quarter, different type of staffer, but same customer base/type

• EBITDA margins at NSP have gone from a peak of 30% last cycle to a trough of 20% and rebounded to a new high of 36% implied in the 2019 guide  

• If you look at the small business optimism index it’s down y/y

Conclusion

• We think NSP is set up perfectly for disappointment.  The sell side loves it. Its growing mid teens top line and mid-twenties bottom line.  The PEO model is in the early innings of its penetration story……..But growth feels like it’s slowing at the margin within their customer base, the insurance side of the business feels like it’s over earning, and we remember when despite the positives mentioned above the group could only get 10x earnings much earlier on in the economic recovery (because of insurance stumbles).  Insiders have been selling an accelerating amount of stock since mid-2018.

• Our earnings estimate for 2020/2021 is $5.20/$5.40, what should that earnings stream be worth at this point in the cycle?  13x feels reasonable to us as a place holder (20x for the secularily growing staffing biz, 8x for insurance). If they do run into insurance issues or the economy rolls over it would fall to 10x the lowered set of #s easily.

• Historically it pays to short the stock before concrete evidence that life has gotten tougher surfaces, in prior cycles it has peaked about 12 months before the S&P

Catalyst

-decelerating growth

-general economic softness

-an increase in insurance claims