I Am On The Fence With Barrett Business Services, But Valuation Is Tipping Me Bullish (NASDAQ:BBSI)


During the dreadful market decline that happened in March and April this year, I admittedly relaxed my standards for which companies to invest in. It has been said that nearly any company can be a good investment at the right price, and I am mostly on board with that philosophy. I deployed cash into companies that were mediocre in terms of their past performance and/or future prospects, but they were selling below book and I saw value in the shares. I made double digit profits in a short time frame from Movado (MOV), Escalade (ESCA), and Hooker Furniture (HOFT) among others. It was never my intent to hold these companies for the long-term, but rather to get one last puff out of the proverbial soggy cigar. Having sold out of most of those positions, I find myself with a build up of cash. With the markets recent surge, I have tightened up my standards back to the usual rigor. When I screen for stocks to hold for the long-term, I use the following criteria:

– Return on Invested Capital in excess of 15%.

– Minimal debt.

– High insider ownership.

– 3-5% annual revenue growth in the last five years.

– P/E ratio below 20.

– Quick ratio above 1.

This screen usual narrows the invest-able universe down to only a couple dozen stocks. I allow for a little wiggle room on occasion, but that is generally what I look for. One company that came across my screen this past week is Barrett Business Services (BBSI), a business solutions consulting and staffing company.

My intent with today’s article is to explain why I believe that BBSI is worth the short-term risk of a very probable stock price decline. Their long-term prospects are quite good. Bottom line up front: there are many unknowns. The situation with coronavirus is a big question mark all by itself, and BBSI has out-sized exposure to California, a COVID-19 hotspot. Relatedly, BBSI has raw exposure to economic cycles. Add to that a brand new CEO and the launch of a new software platform that has yet to prove itself, short-term price fluctuations might be severe. That being said, BBSI is selling well below what they are worth in even a meager growth scenario. They are soon to be licensed to operate in all 50 states, whereas currently they are only in 29. This should give them access to new and larger customers. The primary concern is liquidity, but if they can get through this crisis there is reason to be exceptionally bullish.

Business Overview

According to the 10K, BBSI,

… is a leading provider of business management solutions for small and mid-sized companies. The Company has developed a management platform that integrates a knowledge-based approach from the management consulting industry with tools from the human resource outsourcing industry. This platform, through the effective leveraging of human capital, helps our business owner clients run their businesses more effectively.

I couldn’t get a really granular view of their business model from this description, so after further research here is my own synopsis of what they do.

BBSI operates 57 offices in 13 states. Those offices are staffed with teams that partner with nearby business to offer both consulting and staffing services. They give advice and provide employees. One of their main functions is to take over the administrative functions (payroll, taxes, workers compensation) of the entity under a co-employment agreement. After streamlining administrative functions, they move on to help improve existing processes, implement better practices, train supervisors, and develop leaders. Finally, they move on to a “more strategic and forward-looking” stage “with a goal of cultivating an environment in which all efforts are directed by the mission and long-term objectives of the business owner.” They refer to this entire process as a “structured three-tiered progression”. They currently have relationships with 7,200 different businesses in various stages of this progression.

BBSI also provides a workers compensation package:

BBSI has the ability to provide workers’ compensation coverage as a means of meeting statutory requirements and protecting our clients from employment-related injury claims. Through our third-party administrators, we provide claims management services for our clients. We work aggressively to manage and reduce job injury claims, identify fraudulent claims and structure optimal work programs, including modified duty.

In order to provide workers compensation coverage, BBSI establishes a liability reserve for future claims and has an investment portfolio that they have built up in order to deal with those future claims. Digging into the details, we discover a very bullish bunch of data. First, we have to understand their methodology for estimating future liabilities:

We recognize our liability for the ultimate payment of incurred claims and claims adjustment expenses by establishing a reserve which represents our estimates of future amounts necessary to pay claims and related expenses with respect to workplace injuries that have occurred. When a claim involving a probable loss is reported, our independent third-party administrator for workers’ compensation claims (“TPA”) establishes a case reserve for the estimated amount of ultimate loss. The estimate reflects a judgment based on established case reserving practices and the experience and knowledge of the TPA regarding the nature and expected amount of the claim, as well as the estimated expenses of settling the claim, including legal and other fees and expenses of claims administration.

Beyond this, they also build up a reserve to handle any expensive surprises related to:

– Future claim payments in excess of case reserves on recorded open claims;

– Additional claim payments on closed claims; and

– Claims that have occurred but have not yet been reported.

In other words, not only have they built up reserves according to all known claims, they also have a “just in case” buffer. As of their last 10Q, liabilities associated with workers compensation amounted to $445,310,000. Assets set aside to handle those liabilities amounted to $466,677,000. 65% of those assets are for “just in case” issues. In other words, their workers compensation liabilities are OVERfunded by almost 5%. The assets in this account are invested primarily in both government and corporate bonds. The bullish part of all this is that if those liabilities never materialize, the “just in case” surplus can result in favorable adjustments that will juice EPS and free up restricted cash for use in everyday operations.

Economic Cycle Exposure

BBSI revenue is based on some calculus between how many employees they are supporting with their partners and how much money those employees make. Therefore, fluctuations in employment rates and wages at small business have a tremendous impact on BBSI revenue. Obviously, a recessionary environment is terrible for their business model, especially when the recession is a result of many small to medium-sized businesses being completely shut down to try and deal with COVID-19. Using data from Paychex.com, we see how much the job market is struggling:

Small Business Jobs Index

*images from Paychex.com

Small Business Wage Data:

The number of people employed and the number of hours worked have both gone sharply down, though wages have stayed strong. We can get further insight by breaking things down into specific states. BBSI has operations in the following states, by concentration, as of March 31, 2020:

*Image from 10K

If we compare this to a breakdown of employment by region and state, we see that BBSI has tremendous exposure to the geographies that are currently struggling the most, namely the West:

Regional and state employment 12-month change:

*Image from Paychex.com

In their recent conference call, they provided further details regarding their specific clientele:

… our client portfolio is skewed heavily to the blue and gray collar industries. We do not have clients in the most distressed industries, such as airlines and cruises. Of our portfolio of clients, some may feel disruption in their specific industry or may be impacted by shelter-in-place inefficiencies in their geography. 18% of our clients as a percentage of billings would be minimally affected by COVID and we are seeing gross billing slow from flat to down 7% in April.

This would include, waste management, janitorial, maintenance and landscaping. 65% of our clients as a percentage of billings would be moderately affected by COVID and we are seeing gross billings decrease 7% to 15% in April. This would include contractors, construction, transportation, logistics and manufacturing. 17% of our clients as a percentage of billings would be severely affected by COVID and we are seeing gross billings decreased from 15% to 50% in April. This would include restaurants and hospitality, retail and wholesale sales and professional services.

Clearly, they are going to be facing huge pressure in billings, in large part due to geographic exposure.

Assessment of past performance

In line with the screening criteria I mentioned at the outset of this article, I want to outline how BBSI fares under my chosen metrics:

– ROIC has been above 20% since 2015.

– The only debt on their books is a $4 million mortgage for corporate headquarters.

– Revenue growth has averaged 6% every year for the past five years.

– P/E ratio is at 8.4.

– They fail on the acid test with a ratio of 0.75, so that is a big mark against them, particularly in this environment where liquidity is important to weather the storm.

– Insider ownership is too low for my liking, at 2.2%. That raises concerns about alignment with shareholder interests.

The insider ownership I can overlook. The liquidity issue is more concerning, especially since even with a full draw on their revolver of $33 million they still wouldn’t be able to satisfy their current liabilities. Inclusive of their revolver, the quick ratio is still less than one, coming in at 0.85. They did engage in layoffs and furloughs due to the downturn in business activity, each of which will save them $140,000 weekly. This, in conjunction with the elimination of temporary employees, reducing hours worked, and closing three branches to save on lease expense, will help a lot.

There has been a prolonged decline in several other metrics that indicate a deterioration in the vitality of their operations. In my opinion, the best gauge of the health of their business is how much operating cash they generate per employee. If each person is becoming less productive over time, then what promise do they have for the future? For purposes of this exercise, I left out temporary staff due to the high variability of that segment and it’s low percentage of overall income. Numbers are as of March 31, 2020:

2015 2016 2017 2018 2019
Cash per employee 171,769 121,766 165,205 93,209 96,250

*Data compiled by author

The same general trend is true of other similar measurements like revenue per branch or income per client. Yes, they are growing the raw numbers of revenue, income, etc., but when put in context of other factors, their business is actually deteriorating. Which is also why revenue growth has slowed every year:

2013 2014 2015 2016 2017 2018 2019
Revenue % change 32% 19% 16% 13% 9% 2% .17%

*Data compiled by author

Some of this can be explained by the time needed for new branches to ramp up. More from the conference call:

At the end of April, we will have 57 branches and the stratification is as follows. We have 18 mature branches with run rates in excess of $100 million. This is a measure we used to indicate a branches ability to increase leverage. We have 20 emerging branches running between $30 and $100 million. We have 19 branches we consider developing with run rates of up to $30 million. We also have five satellite operations that focus on staffing and are typically managed by another branch.

If they stop opening new branches and focus attentions on ramping up activity at each location, both revenue and profitability could explode. The issue I see is that a lot of these branches have been around a long time. Why are only 18 of them in the mature stage? Here is the cadence of total branches:

2003 2004 2005 2006 2007 2008 2009 2010 2011
Branches 28 30 36 38 44 46 44 43 43

2012 2013 2014 2015 2016 2017 2018 2019 Current
Branches 50 52 54 55 57 58 62 64 57

*Data compiled by author from 10Ks

They have had more than 18 branches for two decades. As I see it, any branch that existed prior to 2005 should assuredly be in a mature stage after 15 years of operations. That, or they simply picked bad locations for their operations. They had 30 branches at the end of 2004. It is concerning that they don’t have more branches generating the $100 million run rate that indicates a mature stage location.

Future Prospects

Even though things have been in decline for a while now, and things are almost certainly going to be terrible in the short-term due to coronavirus, I am actually optimistic about their potential for a turnaround. My reason for this optimism is three-fold.

First, it seems like BBSI had a poor CEO for a while. Things recently changed over and the new guy seems to have promise. I looked up Glassdoor ratings and here are some quotes that provide insight.

As it relates to the past:

– Rife with distrust. Favoritism runs rampant. Poor leadership. Find someone else to run the company. Update systems.

Looking to the future:

– I think Gary Kramer, the new CEO, is very smart and hopefully will make some big changes. They are needed!

– Really excited about the recently announced changes at the CEO level. Things will change for the better, I believe, for employees.

Second, BBSI is launching a brand new software platform. The old one was apparently a reason some customers were leaving. From the conference call:

myBBSI will launch in June and all new clients will be on our new system. We will then convert our existing client base throughout the remainder of the year. We are extremely excited about this technology as it is going to make our clients’ lives and our lives better. Based on our proven track record of adding and retaining business with an average IT platform, our new updated technology platform will be an absolute accelerant to growth. Increasing our ability to be competitive in the market and to go after new business we couldn’t reach before. We can see the finish line and the teams are sprinting to cross it.

Third, BBSI is soon to be approved to operate in all 50 states.

We’ve also applied for our PEO license in every state and we expect to be fully licensed in the next four months. We are currently only license in 20 states, which sometimes inhibits us from doing business with certain clients. This change will be an important catalyst to growth as we will be able to go wherever our clients go. And more importantly, we will be able to land new clients that may have been historically too large for us.

And then when we think about being a PEO in every state that is really going to help us, right. It’s going to help us with larger clients, right, because if you’re a buyer of the PEO, you want contract certainty, you want ease of business, you want to have a PEO that can go everywhere you are or that will go where you are planning to go and we will be able to do that. So we feel like we’re going to be able to have a strategy where we’re going to go at larger clients and be able to service their business everywhere they go.

This last change will prove particularly advantageous, both in terms of the number, and the size, of companies they can partner with. It will all come down to execution. It would make me nervous if they try and grow too fast by immediately propping up branches in all these new states. Rather, being able to partner with larger businesses who operate across state lines is the real advantage.

It is too soon to say how advantageous any one of these things will be or all three taken together. They certainly can be considered as positive catalysts.

Valuation

Here is where we get to the most compelling part about taking a position in BBSI. Even under pessimistic appraisals of their future cash generation potential and strict requirements for rate of return, BBSI is still trading below intrinsic value. Here is my spreadsheet:

*Data from author with help from Google sheets

Notes on the inputs:

– Revenue are assumed to decline 50% this year. The year following, revenues surge 40% after a recovery gets underway. 6% growth is assumed every year then-after until 2025. Notice how pessimistic this scenario is: under these assumptions, revenues never recover to current TTM levels.

– Margins contract down to only 3% this year. This is sinking way down from their 5% margin in the TTM period. Then-after, incremental improvements are made annually that get cash from operations margin up to 8.5% by 2025. For context, the margin at BBSI has averaged 9.8% in the past ten years. In other words, margins never recover to their long-term average.

– CAPEX stays level at 0.74% of sales, in line with their long-term historical average.

– FCF growth in perpetuity is set at only 1%, well below historic averages for general economic expansion.

– Discount rate is pegged at 12%, my required rate of return.

Under these gloomy outcomes, intrinsic value sits at $59. Shares closed on Monday at about $52. Even with this pathetic cash generation, shares are still undervalued by more than 11%.

On the Fence

I am torn on what to do with BBSI. The valuation is too compelling to ignore. That being said, there are extreme risks presently. Recall that BBSI has 64% of their branches on the west coast. Here is a heat map of their locations:

*Image from BBSI.com

And here is a heat map for coronavirus:

*image from Johns Hopkins

Obvious overlap. Particularly concerning is the fluctuation in cases over the past two weeks. The East, which was particularly hard hit at the outset of all this, is starting to ease off. But the West is getting worse:

*Image from NPR

California broke a record last week with 7,000 new cases reported in a single day. Their governor has gone so far as to re-issue stay-at-home orders and shut down the counties hardest hit. The West is getting whacked. BBSI has huge exposure to the West. It might get ugly. Uglier, I suppose. In fact, my scenario above for a 50% drop in revenue might turn into reality if this keeps up. Perhaps as a silver lining, well capitalized companies may need help now more than ever from businesses like BBSI. We got a hint of that in the conference call:

So if you think of our products right now, our teams are gold in the market, right. These business owners that are trying to deal with this on their own – if you do not with BBSI and you’re doing this on your own, this is going to be a real challenging market to do it. We have the teams and the infrastructure that we can through our expertise of digesting these different laws, digesting these different legislations, helping you with understanding it, helping you with your payroll reports, designing it so that you can then file your payroll reports. If you don’t have a banker, we know a banker, we’ll introduce you to a banker and we’ll get you to the front of the line, right. So we’ve done a ton of work in this – in this environment.

And honestly, I think our retention is going to be better than we expected and it’s going to be better than we expected because the value we’re giving right now is going to our clients. So I’m not worried about that so much. I think what we’ll see is, it’s going to be a little more challenging to move business, just because people are kind of hunkered down and they’re not thinking of a bigger world yet, they’re just trying to get through their, managing through their cash flow, that liquidity, go through their plans.

And we’re going to see a little bit of slowdown in client adds, in the second quarter, which we think will pick up in Q3, as the economy opens up and we have a product that we can bring as far as our technology. So I think long term this is going to be good. Unfortunately, it’ll be good news for BBSI, because I think we’re going to get a lot more client referrals, I think we’re going to, we’ve helped a lot. We helped a lot of our distribution partners. Our distribution partners are primarily running small businesses themselves.

When the Cures Act was passed we immediately began to educate our clients on its various programs and assisted our clients in applying for PPP loans. As a result of these efforts we estimate that over 70% of our clients have applied for a PPP loan. This is significant as it will help our most impacted clients stay afloat during this time, and will also benefit BBSI as clients maintain their payrolls.

We’ve helped them with their business. We’ve helped them apply for loans. Right. If we help them in their time in need, then hopefully they’re going to have some tit for tat and refer us more business. So where we truly think that we are going to emerge from the stronger than we answered and we’re very optimistic about the future.

Conclusion

The data is telling me that results at BBSI are going to be BAD this year. But I think their recovery is going to be rather pronounced. So, what do we do?

1) Establish a small position now to add heavily to if the stocks goes back down towards the 52 week low of $27.25. This would allow me to not miss out on gains if things advance from here, but not expose me to too much risk if the price goes against me.

2) I can buy a full position now and maintain intestinal fortitude for the likely losses in the short-term.

3) I can wait for the clouds to clear and potentially miss out on a lot of the upside and start a full position once we get more visibility on how COVID-19 is affecting them. This, along with changes the CEO is able to implement and how well their new software platform is received.

I am leaning towards the last option. There are too many negative catalysts in place for me to risk too much money. I might put a tiny bit of money down on BBSI, but nothing material. I would buy a long-dated call options, but there has been no open interests on those so even placing that order wouldn’t get me far. The truth is that BBSI is trading at exceptionally attractive levels, even if the business struggles in the next five years. The trepidation for me to buy is probably giving in to some anchoring bias here, fixating on where BBSI has traded recently, so that I am overly worried about it going back down there. Investing isn’t easy. It’s hard to lose money in the short-term. But looking at the numerical data regarding their intrinsic value, I see a big margin of safety at these levels with BBSI. So long as their liquidity holds up to get them through this, the stock price doubling in the next two years is likely.

Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in BBSI over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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