Description

Company Overview

Barrett Business Services, Inc. (BBSI or the company) is a Vancouver, WA based business services provider. This $480mm market cap business offers an attractive way to invest in strong SMB employment growth, wage inflation, and rising interest rates. I believe 60%+ returns are achievable over the next two years using conservative assumptions.

The company’s two primary offerings are Professional Employer Services (PEO) and Staffing. The company currently has over 5,000 PEO clients with more than 170,000 underlying employees. When signing up a new customer, BBSI establishes a co-employment relationship with each client company where BBSI becomes the employer-of-record. BBSI will then assume responsibility for payroll and taxes, workers’ comp, healthcare insurance, retirement plans, compliance and other admin functions while the client retains control over their workforce and staffing decisions. In addition to BBSI providing “outsourced” HR services, the bulk purchasing power of a 170,000+ workforce allows BBSI to extract significant cost savings for its SMB customers when bidding for insurance or other services. The staffing business, which makes up a smaller portion of the firm’s profits, provides on-demand short-term staffing, permanent placement, and long term or indefinite-term placement. For additional background on BBSI and its operational history, please see the previous VIC write-ups on the company.

Why the opportunity exists

In a bull market where the broader indices continue to “melt-up” every day, BBSI’s stock is up only 6% over the last 12 months. I believe this is due to several historical issues that the Street is having trouble moving past.

• Previously under-reserved insurance liabilities – PEO’s typically self-insure their outsourced PEO employees’ workers’ comp claims. Workers’ comp is a longer tailed liability and can be manipulated in the short-term if inadequate reserve assumptions are made. In Q3 2014, BBSI took an $80mm charge because it had under-reserved its workers’ comp liabilities. This led to a shareholder lawsuit (which was resolved) and an SEC investigation (which is still pending but unclear if any action will be taken). BBSI was required to use its cash on hand, a $40mm loan from Wells Fargo, and a portion of its earnings in 2015 and 2016 to plug this $80mm hole. By Q3 2016, BBSI had fully repaid the loan and returned its balance sheet to a net cash position.
  
  In January 2015 the company moved the vast majority of its policies to reinsurer Chubb Limited (formerly ACE Group). Now, not only does Chubb examine BBSI’s reserve assumptions, the company also hires an independent actuary to review their reserves each quarter. In the states where BBSI still self-insures, the company is responsible for the first $5mm of most WC claims and Chubb will cover any overage.
  
  
• Fired CFO Who Committed Accounting Fraud – The prior CFO was fired in early 2016 after he disclosed that he had made unsupported journal entries in the company’s financial records in 2013. These entries were immaterial and simply involved the attribution of expenses to the wrong expense line items. There were no variances to reported profits or cash earnings. Regardless of the immateriality, this discovery was not well received by the investment community. While BBSI went through the lengthy process of restating financials, the company was almost delisted due to non-compliance with NASDAQ listing requirements. The SEC and DOJ have also opened investigations as a result of these accounting misstatements. Both of these investigations are still pending and may ultimately result in fines, although I believe only the CFO has legal exposure to the DOJ investigation. I believe any fine will be manageable given BBSI’s solid balance sheet and cash generation.
  
  The company has since hired a new CFO, Controller and Assistant Controller and has invested in additional headcount in the finance and compliance departments. The new CFO, Gary Kramer, has significant insurance experience having served in a wide variety of roles for 12 years at Chubb Limited prior to joining BBSI. Since making these staff upgrades, BBSI has addressed all but one required remediation plan related to IT controls. Management expects all material weaknesses identified during its accounting review to be remediated by the end of 2017. Furthermore, the company hired Deloitte as their new auditor in September 2016 (previously Moss Adams).
  
  
• Underfollowed – There is currently only one sell-side research firm covering BBSI down from three prior to the accounting scandal. The only firm, CJS, waited until September 2017 to re-initiate coverage. For a $480mm mkt cap business this is unusual and I am hopeful more firms will choose to resume coverage as the market cap grows. Shares are also somewhat illiquid with a 3 month ADTV of ~$2.2mm.
  
  

Why is this a good business to own?

• Reported Financials mask a highly attractive business model – BBSI appears to have very low operating margins of ~3.5-4%. In reality, this is simply an accounting construct – as most of the payroll of its PEO and temporary staffing employees must be recognized as revenue under US GAAP rules. If you were to net out all of the revenues and expenses that are really just pass through items, you would see that BBSI has a very attractive financial profile. I estimate that EBITDA margins are in the mid-20% range. This is still below the non-GAAP EBITDA margins one of their more white-collar skewed peers Tri-Net discloses (~33-34%). Another way to look at the attractiveness of BBSI’s business model is its high capital efficiency. FCF conversion is in the low 90%’s and FCF generally equals net income due to very limited capex.
• Sticky, Diversified Revenues – Customer contracts are typically 1-year in length and are renewed annually. Revenues can be considered somewhat recurring with client retention rates that have been in the low 90% range for years (churn includes customers lost due to M&A or closure in addition). This retention rate is also lowered because BBSI will regularly cancel contracts at weak customers due to credit risk/AR issues or if they are not adhering to BBSI’s strict workers’ comp and safety mitigation guidelines. No client represents more than 1% of revenue.
• Clean balance sheet – Other than a $4.4mm mortgage on company headquarters, BBSI has no debt. In addition, the company currently holds ~8% of its market cap in unrestricted, net cash.
• Attractive Industry with long term tailwinds
  • The inexorable tides of increased government regulation and HR complexity create the need for either larger HR departments or outsourced PEO’s. For a SMB, it is logical to want to outsource compliance and HR functions to a knowledgeable service provider who is always up to date on the latest regulations. Outsourcing can typically be done at a lower cost per employee, is a variable cost vs. hiring full-time HR employees, and it frees up executive capacity to focus on revenue generating activities.
  • Underpenetrated – In the U.S., there are ~50mm people employed by SMBs with employee headcounts that are optimal for the PEO model. Out of these, approximately 4mm employees operate under an outsourced model meaning PEO penetration only around 8%. Even recognizing that not all of these SMB’s are a good fit for the PEO model, it shows the market is still vastly underpenetrated. This means that PEO’s don’t have to compete against each other for market share and are instead focused on converting firms from in-house HR solutions. This dynamic has been confirmed by BBSI management who claim that few of their new customers have ever used a PEO provider before.
  • There is an element of pro-cyclicality in the PEO business model. This is attractive right now with the economy currently humming along. SMBs are growing, hiring is strong, and workers are taking more hours. All these factors lead to improved “SSS” at existing PEO clients. In addition, the payment structure most PEO’s use is generally based on a percentage of hourly wages. This means BBSI can pass along price increases when wages are rising without actually having to renegotiate a higher rate.
• Significant Whitespace Opportunity
  • At the end of 2017, BBSI is expected to have 60 branch locations. Going forward, the company targets 5-7 new branch openings a year which translates into low teens to HSD percentage unit growth.
  • It costs BBSI ~$500k to get a new branch team up and running – Based on this capital contribution and the Company’s current profitability, I estimate the ROIC on mature branches is well in excess of 100%. BBSI also uses unit level profit sharing to incentivize performance and create alignment of interests with its local teams.
    
  • The only market that is even close to maturity is BBSI’s core California market with 21 branches. Even in California, BBSI continues to open new business units since the penetration of potential customers remains very low. The goal is to have one unit covering no more than a 50 mile radius since this improves customer service and reduces the amount of time managers have to waste driving around their coverage area.
  • On the East Coast, the company is just starting to reach critical mass. The Baltimore branch is acting as the East coast hub and already exceeding $100mm of gross revenue. BBSI plans to expand into adjacent markets in the mid-Atlantic, seeding each new branch with existing clients to help it get to profitability faster. This strategy also frees up capacity at mature branches like Baltimore so that they can sign new clients located closer to the center of their geographic radius.
  • Now that BBSI has moved to its workers’ comp reinsurance program to Chubb, they can sell workers’ comp in any state. When BBSI self-insured, there was additional complexity expanding into new states.

Variant Views/Upside Drivers

• New Workers’ Comp Investment Float – Starting in Q2 2017, BBSI negotiated changes to its fronting arrangement that allow the company to invest the assets in the Chubb Trust into a conservative fixed income portfolio. Prior to this change, BBSI was earning virtually no income on the $358mm+ of assets in this account. The company is targeting a duration of 3.5 years and is already earning a 2.1% yield on its newly invested loan portfolio (with an average AA credit rating). On a run-rate basis, this change is expected to add nearly $0.80 to EPS compared to status quo. On top of this, management expects the value of assets in this account to grow at ~$25mm each quarter, further boosting investable assets and income. This development is exciting, because it represents a stealth way to play rising rates too since this portfolio can be fairly quickly recycled into higher yielding securities.
• Depressed Earnings due to Legal/Accounting Issues – Earnings have been depressed the last three years as the company has had to spend money on legal fees, consultants, and additional resources to bulk up its accounting and compliance departments. Most of the additional overhead costs will continue for the foreseeable future, but some one-time implementation and consulting costs should disappear. Furthermore, management has estimated that the ongoing SEC investigations will impact EPS by $0.13 in 2017. This is a discrete expense which I have chosen to adjust for when analyzing BBSI’s future earnings power.
• Lower Tax Rate – 100% of BBSI’s earnings are generated in the U.S. With the passage of the 2018 Tax Reform bill, I anticipate a pro-forma tax rate of 25%. Compared to BBSI’s current tax rate of ~33%, the lower corporate tax rate should lead to ~12% earnings accretion.
• The three items above lead to 2017 run-rate EPS closer to $3.90 compared to current guidance of $3.10.

• Operating Leverage in Branch Model – Not all of BBSI’s branches are operating at their full potential. As each branch scales and hits a tipping point, its incremental margins become extremely attractive.

As long as management continues to open new branch locations, profit margins will be depressed compared to a more mature branch network. Based on management’s disclosure around margins between mature and developing branches, I estimate the Top 30 branches generate the vast majority of the company’s profits.

• Potential for workers’ comp reserve releases – After taking the large reserve charge in 2014, I believe BBSI has become more conservative in its workers’ comp reserve assumptions. Management has decided that they would rather err on the side of caution rather than putting themselves in a similar situation as 2014 again. Based on its recent WC accruals that are now ~20% higher per dollar of employee wages than pre-2015, I believe there is room for some WC reserves to be released in future periods. Since WC is generally a longer tail policy and can sometimes take years to fully close claims I think it will take 3-4 years from the point when BBSI began taking a more conservative approach in 2015 to fully recognize this benefit. Most likely starting in late 2018 or 2019, I anticipate favorable reserve adjustments that would increase reported earnings. Since the start of 2015, management has already released $9mm of accrued reserves (~2-3% of WC liabilities). I feel this provides credibility to this argument as management would be unlikely to reverse these charges so rapidly unless they felt there was a large reserve cushion. The company’s reserve requirements are evaluated quarterly by an independent actuary, not BBSI. Nevertheless, because I don’t have enough granular detail on BBSI’s historical claims, I have not modeled any reserve benefit into my forecast.
  
  

Financial Forecast

BBSI should be able to sustain its historical growth rates in the mid to high teens barring a recession. In the model, I conservatively estimate that gross revenues grow in the low-teens from 2017 to 2020 driven by several factors:

• New client additions at existing branches (MSD % top-line contribution)
• New branch locations (HSD unit growth, but lower impact on revenues of LSD)
• Increased SSS (MSD to HSD growth driven by increased wage growth, new headcount additions, and additional hours worked per employee)

In 2015, management began providing rolling 12-month gross revenue guidance. Management is currently projecting 14% NTM growth through the end of Q3-2018. In addition to strong top-line growth, margins could improve slightly driven by the following factors:

• Newer branches continue to mature, resulting in high incremental margins
• Continued cost control at the corporate level and roll-off of one-time finance department investments
• Favorable workers’ comp reserve developments, most likely starting in 2019
• Higher yields than forecast in the Chubb Trust investment portfolio due to rising interest rates

To be conservative, I am currently assuming no operating leverage is achieved in my forecast.

There could be additional upside to my forecast if share repurchases were to resume. BBSI has a history of accretive buybacks and even bought back 30% of its shares outstanding in 2012 from the estate of its late founder. Even excluding this extraordinary buyback, the share count has declined by over 7% during the last 10 years. Buying shares at the currently discounted value would be a compelling use of excess cash.

Valuation & Returns

• As outlined above, BBSI is an attractive business when you peel back the onion. Regardless of its recent troubles, over an extended period of time the company has generated significant economic value. Since BBSI went public in June 1993, shares have compounded at a 14.7% TSR (29x bagger). A company that can distribute the vast majority of its earnings via dividends and buybacks and still grow earnings in the teens should command a much higher multiple than where BBSI currently trades (~14x 2018E P/E).
• Valuation vs. Closest Peers – The closest comps for BBSI are the two other publically traded PEOs:  Insperity (NSP) and Tri-Net (TNET). BBSI trades at a lower P/E than its peers even though it has a net cash balance and should continue to grow at a faster pace.
  • NSP trades at 21.7x 2018 P/E with de minimis net debt.
  • TNET trades at 21.2x 2018 P/E with 1.6x Debt/EBITDA
• Historical Valuation – Prior to BBSI’s workers’ comp reserve charge in Q3 2014, BBSI typically traded at a much higher multiple. The company traded at a ~20x Fwd P/E on average from 2012-2013. This was a period when the broader market was trading at a significantly lower multiple than it does today. A return to historic multiples would provide further upside to my price targets.
  
  

Risks

• Poor WC claims development leads to additional reserve charges
• Economic Recession causes declines in hiring, falling employee wages, or clients go out of business
• Lower interest rates reduce income generated by assets in the Chubb Trust
• Regulatory changes around PEO providers (especially in California)
• East Coast geographic expansion slows or is unsuccessful
• Pricing pressure due to more intense competition than expected from peers
• Larger SEC penalties than expected
  
  

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

• Rising interest rates improve yields in Chubb Trust Investment Portfolio
• Realization of operating leverage in business model
• Favorable workers’ comp reserve releases
• Overhang removal from conclusion of SEC/DOJ investigations or clarity on potential fines
• Continued earnings growth
• Multiple re-rates in line with PEO peers