BARRETT BUSINESS SVCS INC BBSI
July 06, 2016 - 12:35pm EST by
jso1123
2016 2017
Price: 39.25 EPS 4.10 5.00
Shares Out. (in M): 7 P/E 9.5 7.9
Market Cap (in $M): 284 P/FCF 0 0
Net Debt (in $M): -10 EBIT 0 0
TEV ($): 274 TEV/EBIT 0 0

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Description

 

BBSI has finally moved past a series of accounting and governance concerns that have plagued the stock for the past two years.  For investors who look past the noise and at the on-going fundamentals, BBSI is an under-followed, fast growing company trading at a severely depressed valuation. These factors set the stock up for significant price appreciation as we believe BBSI could be trading at $80 within the next year.

 

Background:

BBSI is a Professional Employer Organization (PEO). The company serves as the co-employer of a client’s workforce, and in return for a markup over payroll, BBSI handles payroll, worker’s compensation insurance, compliance and audit, etc.  The stock is currently trading at under 10x their 2016 adjusted EPS guidance of $4.10 per share, while peers Trinet and Insperity trade at 18x and 22x 2016 EPS respectively.  It is worth noting that, despite trading at half the multiple, BBSI is growing revenues, earnings, and customers faster than these public peers.

BBSI trades at a discounted multiple due to accounting concerns that began when the company took a significant charge on its worker’s compensation reserves in Q3 2014. This caused the market to question whether the reassessed reserves were adequate and what the ultimate profitability of the business model really was.

After several quarters of solid execution and a rise in the share price to over $50, BBSI fell significantly again when its Audit Committee ordered an internal investigation into the accounting decisions around the charge. This ultimately led to the CFO resigning on account of his March 2016 divulging of improperly made marks in 2013’s general ledger.  His marks did not affect the net income or cash of the business but they further reduced investor confidence.  Meanwhile, the investigation, the CFO departure, and a revisiting of the timing of the 2014 charge caused BBSI’s financials to be significantly delayed, risking delisting and possible default.

While these events have weighed on the share price, BBSI has since turned the corner, becoming current on its financials as of June 30, 2016. Moreover, the restated financials revealed no significant change in prior period net income. We believe the focus in the story will now turn towards the fundamentals, which remain excellent and should allow the stock to close the valuation gap with its publicly traded peers.

 

Fundamentals:

BBSI had gross revenue growth of 18.6% in Q1 2016 and guided for 18% gross revenue growth over the next 12 months. This solid outlook is supported by a record number of new customer additions in the past quarter. Our own diligence supports continued customer growth.  From our conversations with BBSI customers, we have learned that they are viewed as an indispensable business partner that helps small business owners navigate the headaches of HR, compliance, audit, and worker’s compensation.  

We believe that BBSI will be able to also expand its operating margins over the next several years. This belief is underpinned by the view that BBSI is now substantially over-reserved on its worker’s compensation expense. Recent filings and management commentary provide compelling evidence in support of this viewpoint.

Worker’s Compensation Deep Dive:

BBSI discloses worker’s compensation accruals within its SEC filings, as well as the cash paid out against claims. This shows up as Note 4 of the financial statements.

While worker’s compensation liabilities are paid out over multiple years and it is difficult to break out BBSI’s ultimate liabilities in each year, we can get an estimate of what the average liability is marked at as a percentage of PEO gross revenue over longer periods of time. We do this by looking at the total accruals BBSI has taken over long periods of time (including prior period adjustments, charges, and credits) versus cumulative gross PEO revenues recognized over that same time frame.

When BBSI first took the worker’s compensation charge in 2014, we estimated from the filings that the average liability as a percent of PEO gross revenues was marked at 3.07% from 2005 – 2013.

 

Total Worker's Compensation Liabilities 2005 - 2013 Including Charges & Credits (millions USD)

352

Total PEO Gross Revenues 2005 – 2013 (millions USD)

11,485

Worker's Compensation Liabilities as a % of Gross Revenues

3.07%

 

This weighted average liability is very close to the 3.12% reserve that BBSI has taken on its current period liabilities over the past 12 months. However, BBSI has actually been closing out prior year liabilities for less than they were originally marked down on the balance sheet. This has shown up as credits, or negative prior period adjustments in Note 4 of the SEC filings.

 

Over the past 12 months, BBSI has paid out $82.9mn against claims and has taken $9.9mn in credits. If we assume that those liabilities were marked at the 3.07% of gross revenues we calculated previously, then the claims are actually being settled at under 2.8% of gross revenues.

Weighted Liability Paid Off:

3.07%

Cash Paid Out Against Claims

82.9

Credits Taken

9.938

Credits Taken / (Cash Paid + Credits Taken)

10.7%

Liabilities Settled As % PEO Rev (Weighted Liability x Credits / (Cash Paid + Credits))

2.74%

 

If BBSI is settling past claims for less than where they are marking current period liabilities, then for the company to not eventually take credits on 2015 liabilities, they will have to either have rising frequency, or rising severity.

However, BBSI mentioned on its Q1 2016 earnings call that the trailing 12 month frequency of claims is down 5.3% over the past year, and down 4.6% over the trailing 12 month frequency of claims from two years ago.

This implies that for BBSI to not be conservatively marked on its current period liabilities, severity would have to be up roughly 18-19% over the average of the past few years:

 

Current Reserve Level

3.12%

Settled Reserve Level

2.74%

Current Reserve / Settled Reserve

13.9%

Frequency Decrease

5%

 

 

Implied Severity Increase

18.9%

 

However, the management team also stated that severity trends are stable versus past years. This statement leads us to believe that the ultimate liabilities on accident year 2015 are likely to come out lower than BBSI has marked them for on its balance sheet. This should flow through into higher earnings for the business.

As a final, simpler check on the conservative nature of the liabilities today, we note that BBSI disclosed that total open claims are up 13% over the past year, while worker’s compensation liabilities are up 14.4% over the past year.

Therefore, while BBSI has been settling prior year period claims for less, the past year has been marked so high that liability per claim on the balance sheet has actually gone up!

 

Significant Upside in the Stock:

BBSI’s conservative worker’s compensation reserves, high revenue growth, and the ability to drive operating leverage through economies of scale on other cost aspects of the business give us high confidence in significantly higher future EPS. We think BBSI can meet its $4.10 adjusted EPS target in 2016, and then do $5+ in EPS in 2017.

A 16x multiple on $5 of 2017 EPS would yield a $80 stock price, over double today’s levels. We believe this is outcome is probable as BBSI’s peers are valued at higher multiples while growing slower than BBSI.





I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

  • Continued growth in EPS 
  • Analyst Coverage
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    Description

     

    BBSI has finally moved past a series of accounting and governance concerns that have plagued the stock for the past two years.  For investors who look past the noise and at the on-going fundamentals, BBSI is an under-followed, fast growing company trading at a severely depressed valuation. These factors set the stock up for significant price appreciation as we believe BBSI could be trading at $80 within the next year.

     

    Background:

    BBSI is a Professional Employer Organization (PEO). The company serves as the co-employer of a client’s workforce, and in return for a markup over payroll, BBSI handles payroll, worker’s compensation insurance, compliance and audit, etc.  The stock is currently trading at under 10x their 2016 adjusted EPS guidance of $4.10 per share, while peers Trinet and Insperity trade at 18x and 22x 2016 EPS respectively.  It is worth noting that, despite trading at half the multiple, BBSI is growing revenues, earnings, and customers faster than these public peers.

    BBSI trades at a discounted multiple due to accounting concerns that began when the company took a significant charge on its worker’s compensation reserves in Q3 2014. This caused the market to question whether the reassessed reserves were adequate and what the ultimate profitability of the business model really was.

    After several quarters of solid execution and a rise in the share price to over $50, BBSI fell significantly again when its Audit Committee ordered an internal investigation into the accounting decisions around the charge. This ultimately led to the CFO resigning on account of his March 2016 divulging of improperly made marks in 2013’s general ledger.  His marks did not affect the net income or cash of the business but they further reduced investor confidence.  Meanwhile, the investigation, the CFO departure, and a revisiting of the timing of the 2014 charge caused BBSI’s financials to be significantly delayed, risking delisting and possible default.

    While these events have weighed on the share price, BBSI has since turned the corner, becoming current on its financials as of June 30, 2016. Moreover, the restated financials revealed no significant change in prior period net income. We believe the focus in the story will now turn towards the fundamentals, which remain excellent and should allow the stock to close the valuation gap with its publicly traded peers.

     

    Fundamentals:

    BBSI had gross revenue growth of 18.6% in Q1 2016 and guided for 18% gross revenue growth over the next 12 months. This solid outlook is supported by a record number of new customer additions in the past quarter. Our own diligence supports continued customer growth.  From our conversations with BBSI customers, we have learned that they are viewed as an indispensable business partner that helps small business owners navigate the headaches of HR, compliance, audit, and worker’s compensation.  

    We believe that BBSI will be able to also expand its operating margins over the next several years. This belief is underpinned by the view that BBSI is now substantially over-reserved on its worker’s compensation expense. Recent filings and management commentary provide compelling evidence in support of this viewpoint.

    Worker’s Compensation Deep Dive:

    BBSI discloses worker’s compensation accruals within its SEC filings, as well as the cash paid out against claims. This shows up as Note 4 of the financial statements.

    While worker’s compensation liabilities are paid out over multiple years and it is difficult to break out BBSI’s ultimate liabilities in each year, we can get an estimate of what the average liability is marked at as a percentage of PEO gross revenue over longer periods of time. We do this by looking at the total accruals BBSI has taken over long periods of time (including prior period adjustments, charges, and credits) versus cumulative gross PEO revenues recognized over that same time frame.

    When BBSI first took the worker’s compensation charge in 2014, we estimated from the filings that the average liability as a percent of PEO gross revenues was marked at 3.07% from 2005 – 2013.

     

    Total Worker's Compensation Liabilities 2005 - 2013 Including Charges & Credits (millions USD)

    352

    Total PEO Gross Revenues 2005 – 2013 (millions USD)

    11,485

    Worker's Compensation Liabilities as a % of Gross Revenues

    3.07%

     

    This weighted average liability is very close to the 3.12% reserve that BBSI has taken on its current period liabilities over the past 12 months. However, BBSI has actually been closing out prior year liabilities for less than they were originally marked down on the balance sheet. This has shown up as credits, or negative prior period adjustments in Note 4 of the SEC filings.

     

    Over the past 12 months, BBSI has paid out $82.9mn against claims and has taken $9.9mn in credits. If we assume that those liabilities were marked at the 3.07% of gross revenues we calculated previously, then the claims are actually being settled at under 2.8% of gross revenues.

    Weighted Liability Paid Off:

    3.07%

    Cash Paid Out Against Claims

    82.9

    Credits Taken

    9.938

    Credits Taken / (Cash Paid + Credits Taken)

    10.7%

    Liabilities Settled As % PEO Rev (Weighted Liability x Credits / (Cash Paid + Credits))

    2.74%

     

    If BBSI is settling past claims for less than where they are marking current period liabilities, then for the company to not eventually take credits on 2015 liabilities, they will have to either have rising frequency, or rising severity.

    However, BBSI mentioned on its Q1 2016 earnings call that the trailing 12 month frequency of claims is down 5.3% over the past year, and down 4.6% over the trailing 12 month frequency of claims from two years ago.

    This implies that for BBSI to not be conservatively marked on its current period liabilities, severity would have to be up roughly 18-19% over the average of the past few years:

     

    Current Reserve Level

    3.12%

    Settled Reserve Level

    2.74%

    Current Reserve / Settled Reserve

    13.9%

    Frequency Decrease

    5%

     

     

    Implied Severity Increase

    18.9%

     

    However, the management team also stated that severity trends are stable versus past years. This statement leads us to believe that the ultimate liabilities on accident year 2015 are likely to come out lower than BBSI has marked them for on its balance sheet. This should flow through into higher earnings for the business.

    As a final, simpler check on the conservative nature of the liabilities today, we note that BBSI disclosed that total open claims are up 13% over the past year, while worker’s compensation liabilities are up 14.4% over the past year.

    Therefore, while BBSI has been settling prior year period claims for less, the past year has been marked so high that liability per claim on the balance sheet has actually gone up!

     

    Significant Upside in the Stock:

    BBSI’s conservative worker’s compensation reserves, high revenue growth, and the ability to drive operating leverage through economies of scale on other cost aspects of the business give us high confidence in significantly higher future EPS. We think BBSI can meet its $4.10 adjusted EPS target in 2016, and then do $5+ in EPS in 2017.

    A 16x multiple on $5 of 2017 EPS would yield a $80 stock price, over double today’s levels. We believe this is outcome is probable as BBSI’s peers are valued at higher multiples while growing slower than BBSI.





    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    Messages


    SubjectDOJ investigation
    Entry07/06/2016 01:17 PM
    Membernathanj

    jso1123, could you comment the DOJ investigation they buried in the latest 10-Q?

    "The Company was also advised by the United States Department of Justice in mid-June 2016 that it has commenced an investigation. BBSI is cooperating fully with the investigations."


    SubjectRe: DOJ investigation
    Entry07/06/2016 01:37 PM
    Memberjso1123

    Hi nathanj,

     

    Given that the former CFO self-reported fraud, we don't think the DOJ investigation is much of a surprise. We also don't think it is a material negative; maybe a perception overhang, but not something that impacts the (quite high) earnings power of the business.

    The skeletons are out of the closet, the financials have been restated with no material changes, and as we discussed in the write-up, the insurance reserves are substantially conservative. We think this drives a higher share price over time.


    SubjectQ2 Earnings Recap
    Entry08/11/2016 11:26 AM
    Memberjso1123
    BBSI reported solid Q2 results this week, providing incremental visibility into meeting or exceeding their 2016 EPS guidance and growing nicely into 2017. Adjusted for one-time legal and restatement expenses, earnings were $1.40 per share, up 16% yoy. Net client adds were up 32% yoy in the quarter and 25% yoy through H1 2016, supporting sustained mid-teens gross revenue growth.
     
    The worker's compensation liability looks increasingly conservative. BBSI management disclosed that open claims were up 7% yoy and LTM frequency is down 8% yoy. Meanwhile the worker's comp liability is up 16% yoy. Put another way, BBSI likely saw open claims flat to down sequentially. In Q1, open claims were up 13% yoy, implying claims were growing 3-4% sequentially through last year.  The deceleration in yoy claim growth from 13% to 7% from Q1 to Q2 2016 implies a 3% sequential decline in open claims. However, the worker's comp liability actually grew $12mn, or 4.5% sequentially. These reserves appear to be incredibly conservative.  
     
    If these trends hold, we believe BBSI will see material leverage in its worker's comp expense line in future years, which would provide a significant tailwind to future EPS. An additional tailwind to earnings that appeared in the 10-Q is that BBSI seems to have overpaid on Federal Unemployment taxes in 2013 and 2014 ($2.6mn total, or ~$0.25 in EPS tax-effected). This should show up as gross margin leverage in the Payroll Taxes and Benefits line. We also suspect that the over-payment has been systematic and will be reflected in on-going margin leverage ie, it is not just a one-time benefit.
     
    BBSI's management is moving past the overhangs of its past and taking the necessary steps to regain investor confidence. The company is bringing on a big 4 auditor, which should be announced at some point in the next several weeks.  The new CFO has a solid insurance background; he joined from ACE Group, BBSI's third party reinsurer, where he would have built a view into BBSI's business practices. 
     

     

    Fundamentally, we believe the the lingering overhang of the accounting restatement and DOJ investigation (which is not tied to business practices) gives investors the opportunity to get into a great business at a very inexpensive valuation.
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