|Shares Out. (in M):||40||P/E||15.2||12.3|
|Market Cap (in $M):||2,835||P/FCF||0||0|
|Net Debt (in $M):||162||EBIT||0||0|
Sign up for free guest access to view investment idea with a 45 days delay.
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
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.
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.
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)
|show sort by|
Are you sure you want to close this position INSPERITY INC?
By closing position, I’m notifying VIC Members that at today’s market price, I no longer am recommending this position.
Are you sure you want to Flag this idea INSPERITY INC for removal?
Flagging an idea indicates that the idea does not meet the standards of the club and you believe it should be removed from the site. Once a threshold has been reached the idea will be removed.
You currently do not have message posting privilages, there are 1 way you can get the privilage.
Apply for or reactivate your full membership
You can apply for full membership by submitting an investment idea of your own. Or if you are in reactivation status, you need to reactivate your full membership.
What is wrong with message, "".