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.
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.
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)
Total PEO Gross Revenues 2005 – 2013 (millions USD)
Worker's Compensation Liabilities as a % of Gross Revenues
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:
Cash Paid Out Against Claims
Credits Taken / (Cash Paid + Credits Taken)
Liabilities Settled As % PEO Rev (Weighted Liability x Credits / (Cash Paid + Credits))
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
Settled Reserve Level
Current Reserve / Settled Reserve
Implied Severity Increase
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.