Barrett Business Services Inc (BBSI) 2014 Q3 法說會逐字稿

Good morning, everyone and thank you for participating in today's conference call to discuss as BBSI's Financial Results for the Third Quarter ended September 30, 2014.

Joining us today are BBSI's President and CEO, Mr. Michael Elich, and the Company's CFO, Mr. Jim Miller. Following their remarks, we'll open the call for questions.

Before we go further, I would like to take a moment to read the Company's Safe Harbor statement within the meaning of the Private Securities Litigation Reform Act of 1995 that provides important cautions regarding forward-looking statements. The Company remarks during today's conference call may include forward-looking statements. These statements along with other information presented that are not historical facts, are subject to a number of risks and uncertainties. Actual results may differ materially from those implied by these forward-looking statements. Please refer to the Company's recent earnings release and the Company's quarterly and annual reports filed with the Securities and Exchange Commission for more information about the risks and uncertainties that could cause actual results to differ.

I would like to remind everyone that this call will be available for replay through November 29, 2014, starting at 3:00 PM Eastern Time this afternoon. A webcast replay will also be available via the link provided in today's press release, as well as available on the Company's website at www.barrettbusiness.com.

Now I would like to turn the call over to the CFO of BBSI, Mr. Jim Miller. Please go ahead.

Thank you, and depending upon where you are dialing in from, good morning or afternoon, everyone. As you saw at the close of the market yesterday, we issued a press release announcing our financial results for the third quarter ended September 30, 2014.

Our third quarter results continue to be balanced by new client additions and strong growth from our existing client base. At 8% same-store sales, we're at the upper end of our high-single digit expectations, while we added net new 182 clients.

These results reflect our continued focus on delivering a management platform that supports well run companies over the long term, as well as the maturation of BBSI's brand in the marketplace.

Before taking you to our financial results, I would like to mention that yesterday's earnings release summarizes our revenues and costs of revenues on a net revenue basis, as required by Generally Accepted Accounting Principles or GAAP.

Most of our comments today, however, will be based upon gross revenues and various relationships to gross revenues because we believe such information is, one, more informative as to the level of our business activity; two, more useful in managing and analyzing our operations; and three, adds more transparency to the trends with our business. Comments related to gross revenues as compared to a net revenue basis of reporting have no effect on gross margin dollars, SG&A expenses or net income.

Now turning to the third quarter results. As disclosed in yesterday's press release of the Company's recording an additional charge to the workers' comp claims liabilities of $80 million, the net funding needed for that charge will be on an after-tax basis, which equates to approximately $48 million. I will discuss the charge in greater detail momentarily. In some cases, however, I will discuss our third quarter results without the impact of the charge to provide you with a view of the quarter on more of an isolated basis.

Total gross revenues increased 18% to $900.2 million over the third quarter of 2013, primarily due to the continued build in our co-employed client count and same-store sales growth, coupled with an increase in staffing revenues. Overall PEO gross revenue increased 18% over the third quarter of last year to $851.6 million due primarily to the continued build in our co-employed client count and same-store sales. Our PEO revenues from existing customers increased approximately 8% year-over-year due to increases in both headcount and hours worked. This compares to 13% increase in the third quarter of 2013 and 9% increase in the second quarter of 2014. Staffing revenues for the third quarter of 2014 increased 16% to $48.5 million, primarily due to an increase in revenues from existing customers and new staffing business.

On a percentage basis, setting aside the additional workers' comp charge, gross margin in the third quarter was 4.1% as compared to 4% for the third quarter of 2013. The key drivers of this quarter's gross margin are as follows: direct payroll cost as a percentage of gross revenues declined slightly from 84.2% in the third quarter of 2013 to 84.1% in the third quarter of 2014, which reflects a small increase in the overall average customer market percentage on a year-over-year basis. For the third quarter, payroll taxes and benefits as a percentage of gross revenues were 7.2% compared to 7.6% in the year ago quarter. The lower effective payroll tax rate resulted from our ability to optimize the use of prior wages against the taxable wage base as new customers are brought on board and to arising the overall average wage rates, which allowed the tax ceilings to be reached sooner in the years compared to 2013. This continued the trend experienced in the second quarter of 2014, and we expect a similar rate of savings to continue during the fourth quarter.

During the first quarter of 2014, we announced and began implementing an arrangement with ACE insurance that provides workers' compensation coverage to BBSI clients and their employees in California. The arrangement typically known as fronted program provides BBSI with a use of a licensed admitted insurance carrier in California to issue policies on behalf of BBSI without the intention of transferring any of the workers' comp risk for the first $5 million per claim. The risk of loss up to the first $5 million per claim is retained by BBSI. BBSI implemented this strategy of moving to continuing operations in California.

Under California Senate Bill 863, BBSI will no longer have the ability to be a self-insured employer for workers' compensation in California as of January 1, 2015. BBSI's arrangement addresses the requirements of the SB 863 and allows us to remain in compliance in California. Today, we have transferred coverage of approximately 72% of our clients to the new program and we are on track to have most clients converted by the [end of December].

Moving on to the workers' compensation expense, without the additional charge, workers' comp expense as a percentage of gross revenues was 4.6%, which represents 34 basis point increase over the same quarter a year ago, primarily due to the incremental cost associated with the new ACE program and the higher cost associated with administering our workers' comp program. Looking ahead to the fourth quarter of 2014, we anticipate the level of gross revenues for workers' comp expense to be in the 4.8% to 4.9% range. This projected percentage increase is due to the increase in the accrual rate for claims expense and the continued transition of California customers into the ACE program and the associated incremental expense of that program.

As expected, once all employees in California are completely implemented into the ACE program, which will be fully reflected in our Q1 2015 results, the full burden to the workers' comp expense will be in the neighborhood of 25 basis points to 30 basis points we've previously disclosed. We expect to more than recover this incremental expense with price increases in the market.

SG&A expenses increased 26% to $21.2 million, primarily due to higher management payroll, increased IT spend and other variable expense components within SG&A to support continued business growth. Increased IT expense relates to projects designed to enhance access and delivery of information to the field, as well as improve efficiencies over time. The provision for income taxes in the third quarter without the effect of the additional workers' comp charge was $5.5 million, which represented a tax rate of approximately 35.4%. However, the income tax rate of 30.6% for the third quarter of 2013 was more favorable due to higher-than-projected employment tax credits. As a result of the effect of the large pretax loss from the workers' comp charge which impacts the full year tax rate, we expect the tax rate of approximately 43% for the fourth quarter of 2014 but then a return to a more historical range in the mid-to-upper 30 for 2015.

Now turning to the balance sheet. At September 30, our cash, cash equivalents, marketable securities, as well as restricted securities totaled $167.5 million compared to $143.2 million at December 31, 2013. At September 30, 2014, approximately $15 million of our cash is unencumbered or said another way, not part of our captive insurance subsidiary or our new ACE fronted program. We expect the unencumbered cash to build during the fourth quarter but as we get towards the end of fourth quarter, we will be using a portion of this cash to put into the captive insurance company towards the end of the year.

During the third quarter, we funded approximately $8.1 million of cash into the ACE trust account to supplement our $23 million on deposit at June 30 for our new fronted arrangement with ACE. These funds are included as a component of restricted marketable securities and workers' comp deposits within long-term assets on our balance sheet. The balance in these trust will continue to grow as we transition customers into the ACE program throughout the remainder of 2014.

We generated approximately $33.5 million in operating cash flow during the first nine months of 2014. Much of our cash generated from operations is in the form of free cash flow, except for the build in the workers' comp and safety incentive liabilities as cash used to fund our insurance subsidiaries is primarily generated from the workers' comp expense we recognize but do not immediately pay out to third parties. This is also true of the new funding agreement with ACE that actually flows through our captive insurance company as well.

During the third quarter, we repurchased approximately 28,000 shares for approximately $1.1 million or an average price of $39.95 per share. We currently have approximately 1.1 million of authorized shares remaining on the repurchase program. We will continue to strongly consider share repurchases as a use of available unencumbered cash as the market should present appropriate opportunities.

As we mentioned on our last earnings call, in order to provide investors with a more appropriate forward-looking view of our business, we have initiated a rolling 12-months outlook, which we plan to update on a quarterly basis. As a result, we expect gross revenues for the next 12-month period to increase approximately 18%. Included in this expectation is a high-single digit contribution from same-store sales growth, as well as growth consistent with trends from new business.

Moving on, I'd like to address some recent criticisms of the Company and there really are three issues that I think merit some further discussions. The first topic I'd like to address is adverse development of prior year claims. Over time, we had been seeing adverse development of older claims and we believe that if we could proactively affect those older claims and minimize future development, it would allow us to bring stability to those years and create a basis for estimating costs on a go-forward basis. And I think, as we'll talk about here in a few minutes, the charge we took yesterday will greatly address that issue of adverse developments that we have seen in our history.

The second issue I'd like to address is the IBNR versus case reserves. Our total claims liability is comprised of two components; one, specific case reserves and two, a general provision for future adverse development on known claims and that's referred to as the IBNR portion of the reserve. Typically, there is an expected ratio of IBNR to case reserves. We have continued to progress through the reserve strengthening process in order to move us closer to the ultimate expected level of liability on all open claims, including those in 2012 -- 2013 and 2014. And strengthening claims for 2012 and prior, we accelerated the development of those claims, which had a noticeable impact on our IBNR versus the case reserves ratio.

As we move through the strengthening process, we have transferred IBNR to those specific claims, which increased our case reserves and resulted in a corresponding decrease in the IBNR portion of the overall liability. The charge that we reported yesterday will greatly increase that IBNR component to what we believe to be a pretty conservative amount.

Finally, I'd like to address the issue of the increase in the paid activity. In addition to the strengthening of all open claims for 2012 and prior years, in mid-2013, we initiated a change in reserve practices in which we are now reserving claims more fully early on in the claims life cycle and simultaneously paying more dollars out sooner on those claims, which has allowed us to close more complex claims sooner in their life cycle and to minimize the cost of future legal expense where before that change in practice, we would tend to fight those more complex claims sometimes over the period of several years which would result in increased costs. The change represents management's efforts at putting up dollars on claims quicker and we have seen an increased rate of closure by 27% in the first nine months of 2013 compared to the same period of 2012 and have also seen 69% increase in closure in 2014 versus the same period of 2012 on these claims. Since we're reserving claims at a faster rate, this reduces our loss development factor or LDF. This is a factor that is the multiplier, it takes to -- for us to fully close out a claim after its first year value has been determined. This is a key in really getting a handle on being able to estimate the future cost of claims, which we believe we have a much better understanding and application of.

So, while there's been an increase in the incurred and paid activity, we have done so intentional with the knowledge that we'll ultimately reduce our overall cost of claims. The combined effort of the strengthened process of 2012 and prior year claims and simultaneous change in our reserve practices on all claims has caused disruption in our actuarial data for both the incurred and paid values. This disruption we're seeing impacts 2012 and prior years and impacts also 2013 and 2014 as well and we believe it will take some time for that new strengthened data to normalize and the positive impact of the changes in practice to fully be reflected in that data.

Now I'd like to comment on the Company's $80 million workers' comp charge we reported yesterday, and some of the financial effects of that charge. We anticipate our loss accrual rate for workers' comp claims to increase potentially up to 20 basis points or up to 5% of our total workers' comp expense going forward. We believe that the current price adjustments being made as a result of the ACE program will also grow towards mitigating the impact of the accrual rate increase. In order to fund the charge, we anticipate using a combination of cash on hand and debt financing. Our existing credit facility with our principal bank provides current borrowing capacity of up to $40 million. We've entered into the discussions with the bank to increase the borrowing capacity to meet the liquidity needs of the Company. As the charge flow through our captive insurance company, we have some flexibility as to the timing of putting that money into the captive and that is we do not have a hard stop date such as December 31, 2014. With that said, we will work on moving the funds into the captive in an orderly manner so that we remain in compliance with the governing captive insurance regulations.

The Company's free cash flow was typically nears net income continues to remain strong. The free cash has been primarily used for payment of dividends and stock buybacks with minor CapEx activity. And during 2014, some free cash has been used into the initial funding of the ACE program, but I should state that the ACE program is primarily funded from the workers' comp expense that we recognized but do not immediately payout. We anticipate that the borrowings connected with funding a portion of the maximum expected charge we've reported yesterday can be repaid within a range of three to five years at a maximum. I'd like to say a couple of things related to that. And looking back at our history of our equity and going back to the last seven years from 2008 to 2014, we have spent a combined $109 million for stock buyback and dividends paid out. So, I think that needs to be said because I think that's a valuable piece in viewing our Company. We continue again to remain a very good strong cash generating operation and continue to see that for the foreseeable future.

One other last thing I'd like to say about the charge we took in yesterday's release. We received the [9/30 actuarial] report during mid-October and as we went through the report and we're doing our own analysis and have been looking at information for a while as we went through that strengthening process coupled with the Willis Claims Audit that Mike will talk about here in a few moments, it's taken several weeks to analyze the data used and to understand how the data and the change that's been effected in that data by practices that we've undertaken to make process improvements, it really was in control. Yesterday morning, we finally concluded that we would use the actuarial report as our best estimate, as it was the best supportable information that we have and we felt that it was important that with the information we now had on hand that it was time to recognize the charge.

Now I would like to turn the call over to the President and CEO of BBSI, Mike Elich, who will comment further on the recently completed third quarter. Mike?

Good morning, and thank you for being on the call. Before we get into discussing the Company's performance in the quarter, I'd like to take a moment to comment on the efforts and the effects of -- in the area of workers' compensation expense and changes.

First a little bit of history, I intended to discuss the claim strengthening process. Looking back, after taking a charge in 2012 for fourth quarter 2011, we started to look at how we could gain a better understanding of what our ultimate expected liability was, as we were continuing to be affected by a tail factor of older claims continuing to dwell. Even though we had taken charges in 2001, 2009, 2011, we were neither solving the problem nor getting any closer to an answer.

In 2012, we started the process of understanding what the ultimate level of liability would be if we stress each claim. We continued the process in 2013, as we realized that it made no difference to the actuarial process unless those dollars moved from IBNR to case reserves as incurred. In July 2013, we initiated a reserve study process on claims 2012 and prior. The process was intended to strengthen the reserves of all claims 2012 and prior to a level of probable ultimate expected. As the process remained a work-in-process completed this quarter, we have seen year-to-date closures of 2014 claims -- excuse me, we've seen year-to-date closures in 2014 of 344 claims or 26% of claims strengthened. We have generated a credit of $3.4 million or 20% credit of incurred dollars on those claims.

In conjunction with the reserve strengthening process, we initiated a reserve study and engaged the Willis Claims Audit Team to review and reviewing a target sample of claims, we believe to have the highest -- we took a sample of the highest probability claims with complexity. Willis completed the study at the end of the third quarter, concluding that strengthened reserves in total were more than 100% of the ultimate estimated amount. That finding along with the credits we are seeing on closed claims, gives us confidence that strengthening process is having the intended effect and we have a much better basis to benchmark against when looking at 2013 and 2014. Concurrently, in mid-2013, we initiated a change in reserve practices encompassing three areas: adjusting claims to put dollars and to incur more quickly on all claims.

We have increased our claims teams allowing for adequate capacity to manage the best practices and we are paying claims faster and we are closing claims faster, as a result of better visibility into the long-term liability. As a result, we have seen incurred amounts on claims increase by 78% in the first nine months for 2013 claims compared to the same period of 2012 while increased by 149% in the first nine months for 2014 claims compared to the same period of 2012. The combined factors of the strengthening process and the change in practice are causing disruption in the data that is making it difficult for the actuarial models to provide an estimate of probable liability. While the actuary has provided his best estimate of $207 million, we believe this number to be conservative. With that said, by taking the charge, we are impacting the obstacle of the unknown tail factor, allowing us to focus on the long-term strategy of the Company.

Moving forward, overall we're very pleased with the results of the last three months. We have made significant progress in all areas of the business since the beginning of 2013. In the quarter, we added 233 PEO clients, a new record. We lost 51 clients, five clients were for AR reasons, 10 clients were cancelled for non-AR issues and lack of tier progression, 16 client businesses sold and 20 left due to pricing to competition or companies that have moved away from the outsourced model taking payroll in-house. This represents an approximate build in the quarter of 182 new clients. Also in the quarter, we saw an 8% build in same-store sales. As we saw clients increase hiring along with the increase in hours worked in the quarter sequentially compared to last quarter, all trends were seen as positive. 44% of clients had a headcount, which is actually up about 5% of what we've seen in the past several quarters. 28% clients reduced headcount and 28% of clients were unchanged. We saw 63% of customers increased payroll while 36% reduced payroll. 64% of clients increased hours worked while 33% reduced hours worked.

Related to pipeline and regional growth, we continue to see strong momentum across all regions. In serving the organization as to forward-looking pipeline strength and general market outlook, we are not seeing change in momentum and things seem to be continuing on-track related to new client adds. Related to structural and organizational build, we continue to expand and build business units as needed to support current and future organizational and market demands. Currently, we have 35 business units supported by 52 branches. We are forecasting for an additional one business unit to start by end of 2014 and have forecasted to build as many as 12 business units in 2015. We will add one additional location in San Mateo, California by the end of 2014. We also continue to see positive momentum with new markets opened in the past two years.

We've accomplished a great deal in 2014. Over the past four years, we have evolved and re-engineered a number of key factors supporting the business model. We now have infrastructure to operate as a much larger company and are starting to see operational efficiencies from various initiatives we have implemented over the past 18 to 36 months. From an organizational perspective, we have just finished our annual all meeting which consists of our senior team and me making -- meeting with each person working for the Company for a full day to focus on our attention on the organization and to mature our Company's culture. My observations from the field over last eight weeks, is that we have never been -- never looked better, leading me to believe that we have turned the corner.

With that, I'll leave you open to questions.

Thank you. (Operator Instructions) Jeff Martin, ROTH Capital Partners.

Mike, could you go in this in detail about the loss development factor specifically, how is that shifting around with this $80 million reserve charge and where ultimately that will settle in do you think?

So what happens with your LDF, as you move your triangles over time and the triangle is already actuary's model of looking at development in dollars from a couple of different angles by year as those years develop over time. So you have a factor of incurred, which is how dollars are put up on claims and then you have a factor of paid, which is how those dollars that are incurred are paid out that move within those triangles. Each year as you have a new claim, you have a basis that's built that over time says that if you had a claim today or you have a lot of claims today, it may take three years, five years, 10 years to get to a full development on those claims.

Well, as you come into -- and if I go back kind of look at old practice, we were -- we tended to put up dollars, and then we kind of wait to see what would happen and then we put up dollars, and this is prior to even 2011, where we would kind of spread that tail out a little bit more where it would take us longer to get to the ultimate incurred, which means bigger LDF begins -- it creeps, it moves from three to four to five to six meaning that ultimately it will take longer for you to realize those same dollars. So it gives you less credit for what you did because it still says that you have a multiplier on how long it'll take you to get to your ultimate expected.

When you step back and you start to step into the process of accelerating that process, you get no credit that says that it's going to take you less time to get those dollars up. In fact, the opposite does happen, you are still pegged to your current LDF which today is closer because of the reserves are strengthening to six or seven. Well, that's actually given us some credit for some strengthening but not really -- actuarial models don't allow for credit to strengthening. So if you took your number at a seven times multiple today, you would take that dollar that you set up and you'd put up and you'd say I have to do it seven more times to get to that number.

Well, as we have moved dollars in the triangle, it's moved our LDF out. The problem with it is, is that it will take a little bit of time to show that even with what we've done in 2013 and what we've done in 2014 that your ultimate tail factor or how faster you're getting dollars up is bringing that LDF down. So today, we believe strongly that the LDF factor is trending lower than five. Some analysis will tell us that maybe it's going to settle in around three. If it does, that tells you that the factors that you are looking at for 2013 and 2014 are roughly double of what you might overall anticipate longer term.

So the LDF is really a product of how the claims move. The problem that we were having in 2012 is that each quarter or each year that you would grow a little bit further and because you would have a development in the claim in 2006, it would move all your estimates, all the way through the model creating a combined effect. It's not until you can back up and you can look into the bucket and say we are 100% full in that bucket or all those claims are fully reserved that you now can say I have a stable base. The problem with actuarial models is they look back and they'll say -- they can't tell whether you're 40% of adequate or you're 50%, or you're 80% or you're 90% and then likewise, they're only going to give you credit for roughly at best 85% to 90% credit, and that's if they even believe that you're 100% full.

So the LDF factor will continue to trend down which -- if given more time, we would have been able to let that play out and then that would have probably had an impact on even the [$207 million] number, but given that where we're at and what we've looked out, we felt that it was the more conservative approach to be able just say, let's get out in front of this tail, make sure that we're in a good position to over time continue to run. And now also that we're running and we've got good picks or good estimates for our core rate both in 2013, 2014 and going into 2015.

Help us understand the timeline for getting more of the clear picture of how that -- this ultimate claim costs are going to play out? Is it a matter of quarters or is it a matter of couple of years?

You'll get different premiums from different people. The actuarial will tell you it's going take you five years, but we feel that with the results that we've seen already in the quarter and then even what seen in October moving forward that it will -- we'll have a better feel and much better idea even by the end of this year what that trend is. We've already seen where that trend is starting to move down and analyzing things from different angles, but if I would say that by the end of this year, you'll see some movement, I would say in the first six months or to the next three quarters getting -- taking us through mid-June or end of second quarter. We'll start seeing that movement and then that will allow for a more accurate basis, I think within the actuarial models.

Assuming that claims, payments and cost of claims and the frequency doesn't change much from here, what kind of scenario we're looking at a year or two down the road in terms of this $80 million increase in reserves. There's a situation where that will need to be un-winded and what kind of scenario is required for that to play out?

Well, I would say two things. One is that, once you've gone through this processing and you get on the other side of that tail and you feel that you're in a very conservative position, you can be very -- I'm not going to be very reluctant to take dollars back to earnings and hopefully we'll be able to put ourselves at higher confidence level and ultimately allow ourselves to maintain a level of adequacy based on the charges that we had and normalize and smooth out the whole business model.

The challenge though, and this is where we were even as much as the last two days as looking at further out. If you take data at the day that you know it's skewed, at some point you're going to find that you could be on the other side of that curve, where in a quarter just as we've had, charges that went up by $10 million, they could go down that much as well. But I think you have a better -- again this was -- we did this because it was in the best interest of the Company. We did this because it gave us a better visibility and one of the things you can't do and this is one of the things that we probably could have done going back to 2013 and 2014 is or even to the claim strengthening process is we could have managed the process a little bit to get to a number that did disrupt data. The problem I had with that is that until you step into the ring and get your path, taking care of and get and know where you're at, it's hard to move forward. And so that was really the process that we used was to just go in and just say, let's look at 100% and a higher probable expected amount and that (inaudible) as we are even seeing in the closed claims to maybe overshooting and at least in some pockets as much as 120% of what was the actual closed out amount, leaving us to point where we can say, we feel very comfortable that we're at least to an adequate level and that we're not under-reserved. The run-off coming back, I think that we'll be watching that very closely quarter-to-quarter and not allow for choppiness coming the other direction over time.

And then diving into the P&L a little bit, SG&A was up pretty dramatically as a percentage of gross revenue. Just curious if there were any unusual items in that, I mean maybe quantifying the cost of working while assuming that you might explain some of that. I'm just curious what kind of SG&A level to expect in the model going forward?

Probably the biggest data component that we saw moving up and we saw this in second quarter too and probably the -- just incremental costs, we had about $1 million in just IT expense and that again is for the various IT projects we've been working on during 2014. And I think we're probably near the peak on those costs and we should see those costs at least level off and probably start to come down a little bit once we get into 2015 but that's probably the single biggest driver of the increase in SG&A.

In the last couple of years, we have been building a lot of infrastructure. We've really had get out front of our growth rate and re-tooling a lot. And we had -- we basically had re-engineered the whole company over the last three years and in doing that, we had to reinvest back a significant amount of dollars to get us to a point where the base that we're running today is actually a good solid base. And we don't see stress in how we're running the Company today. One of those things that you compare that over the last year or even a couple of years and you see that acceleration in SG&A grow. We've had to reinvest a quite a bit, but even in the last -- and sequentially even in the last couple quarters and I'll refer more to like just to our management payroll infrastructure, it's really started to normalize where we're not seeing the big jumps quarter-to-quarter that we were seeing going back six months ago or even a year, 18 months ago.

And then just wanted to touch on funding the captive. I think you said about $46 million would actually need to be funded. Is that taking anticipated tax credits or tax savings?

So that net of $48 million, we will realize [about $32,000 in tax, less cash] paid in 2014, we'll have to carry back to 2013 and 2012 and then that will take care of most of that $32 million and maybe some carry forward into that we'll use as a credit against 2015 taxes when we get into 2015, but that's kind of the tax piece of that, that reduces really the net funding down to $48 million level.

Is that something that could be funded with a surety bond or do you have to put up all cash?

No, we actually have to post that cash. So in looking at our operations, we do have, like I said on my prepared statements, about $15 million in unencumbered cash and we can certainly use a good portion of that as well as the available credit line that we have with our bank. And as we mentioned, we're in discussions with the bank to increase that as well. And just cash flow from operations over the next few years should quite comfortably be adequate to fund those from that level.

We've been asked over a long period of time, what are we going to do with the cash, where your balance sheet -- why do you look at your balance sheet the way you do and the reality of it is, is that, it was hard to say where this whole process would land, but when I was even back as far as three years ago, when we were buying shares back and doing some different things, we were always very careful not to extend our balance sheet or lever ourselves to the point that we couldn't be able to address a situation like this and that's one of the reasons why we have no debt coming into the quarter.

And then I'm asking this question because I've been asked it a lot and I think people would like to hear your response on and if you went back over the course of the last five years and worked in this accrual adjustment, what do you think the earnings of the business historically would look like?

I think you have to look at it from two perspectives. One of the things that gets missed a little bit is, in 2012, we realized that we had to bring our picks up or bring our accrual rate up. And if you go back, even 2011 over 2012 and then even maybe 2011 over 2015 -- excuse me 2013 and 2014, we've increased our accrual rate through increase in pricing and different things by roughly, what 100 basis points to maybe even 120 basis points, while continuing to earn and grow.

So I guess, you can go back as far as even in 2011 and maybe back or even 2012 and back and say, if you were to have accrued another 100 basis points to 120 basis points, where would have you been? The one thing that we're comfortable with is that we've been going through that change over the last couple of years and that's why you don't see our accrual rate or pick going into out of 2014 and into 2015 being that much disrupted by this ultimate new number. And so Jim, if you want to add?

So it's again we're having, I guess what we would call better information as a result of the reserve strengthening process we went through and really know now where 2012 and prior really landed with the passage of time. If you went back into some of those earlier years, they could've been understated $5 million to $6 million in some cases. And as we've seen our financial results over the last couple of years, there has been some adverse development of those prior years and that's what really led us to wanting to get in and do the reserve strengthening program that we did.

Matt Blazei, Lake Street Capital Markets.

Jeff covered a lot of ground there so I wanted a couple more questions just to clarify. You said that the $80 million charge was very, very conservative, and yet I think you also said that even if the trends prove to be better than that conservative number that you don't see that $80 million -- any part of that $80 million coming back. Is that correct?

What I said was in that line, it will take a little bit for that -- we're using evidence of what we're seeing to-date. We're on the strengthening process to give us confidence that, that number is conservative. As we move into future quarters, we'll know more, one. Two, given that the data was skewed, that's what also makes us believe that the report itself puts this to a conservative level. I'm not saying that it won't come back, what I don't want to do is to have one quarter where we're doing something to go, get out in front of this situation and putting ourselves in a position where this becomes really a non-issue.

We go back in our own history and we look at just AR, where back in 1998, we used to deal with AR issues every quarter. And today it doesn't even come up, it's been locked down and we're very solid that way. My view and my hope is that in the next year or so this becomes the workers' comp as a footnote, and it doesn't consume the topic of conversation. If the report -- if future actuarial reviews have that number coming down, we'll be forced to have to take dollars back to earnings, it's just -- but we'll follow the model and follow the process. The one thing that we did in this quarter is we set a new basis for ourselves.

Given that you've taken a very conservative posture on reserves, why do you then also need to increase your accruals by 30 more basis points more going forward?

I think we have mentioned that the accrual rate could be needed to be bounced by 20 basis points in future quarters. But the other piece of that is still we're transitioning into the new ACE fronted program, and that could be where you're getting the 30 basis points increase.

I'd assume that would involve in the increase in this year, that was the assumption. That ACE transition was the part of the 20 basis points to 30 basis point accrual for this year.

Correct. Yes, and so the adjustment to the accrual rate for claims obviously, we'll be watching that closely in 4Q, but that comment was, I guess maybe more for 2015 as we analyze that accrual rate for the new year.

So I guess I'm confused that is, you've taken what you said is a very conservative reserve charge here. Why would the accrual needs to pick up rates even more?

Well, because the charge itself sets the benchmark for where you're at -- where you've been in the past and you're at even in 2013 and 2014. So to-date, you're short of that, and then you -- and until you are given more credit, you start to accrue going into 2015 at a level that's going to support the new base that's been created by the charge. So, it's smart business to make sure that you're not disrupting your overall accrual rate 20 basis point in the grand or scheme of it all is, we will capture that -- we're capturing that actually just through price increases right now, but that's should -- it could be -- we're not -- I don't -- I want them on the right side of the curve, I don't want to get on the wrong side of the curve again.

I guess that I would say that also, we believe that the improvements that we've made in our processes will potentially bring that accrual rate down over time, but until -- again until our data settles out, we just don't know and we need to do plan on maintaining that conservatism.

Dan Mendoza, Prospect.

I had a couple of questions, guys. What are -- I still don't really understand the 20 basis point accrual rate that gets discussed, you also mentioned in that same sense in the press release that it's 5% of total workers' comp on a go-forward basis. So, if it's 4.6% now, should we be using 4.8% or 5% for next year?

I think as you model that out, it's probably going to be in that range for possibly as high as 5%. I think that would be the upper end. And that would (multiple speakers) -- well but that would represent the full inclusion of the ACE fronted cost as well.

One last question on kind of, you talked about the deposit with ACE increasing as you bring more of your customers or clients on to the program. Do you envision there being an increase kind of an overall increase associated with the reserve charge as we kind of move into next year's agreement?

No, the accrual rate again is kind of -- is what you're feeding your collateral agreement. So as your -- that's why you want to get your picks right because those dollars are funding that collateral agreement, which then those dollars are used to ultimately payout claims. So again, we haven't felt like our pick is that far out of line. So, we don't see where that's going to change and we haven't had indication from ACE that, that will significantly. This actually helps the relationship and that it gets us trued up to a point where we, at least are working off a basis of being a more upfront of the process that we still believe it would be. We will be having conversations around that, but we're not seeing where from an earnings basis that will have that much of a change you might fell.

I understand it provides them with sort of the opportunity to come and say look your reserves are volatile or unknown and we need a little bit more collateral to get comfortable. But I guess kind of the related question around that just in terms of timing, you mentioned there is not a kind of a hard date to get your captive funded. But I assume you'd want to get that funded in front of renewing your ACE agreement the beginning of next year?

Well, the funding into the ACE agreement, it's really a separate matter and that's done monthly and we will --

No, not in terms of the deposit, but just in terms of getting the captive fully capitalized before you renegotiate the 2015 fronting agreement?

Yes. I think that timing will -- it will be an [event] of that.

Yes, we will be putting attention to that. We already are. So it's not going to be a delay. We're just going to make sure we take enough time with the process to be on the right side of curve as well.

How far back do these reserve true-ups go? I'm just trying to kind of getting back to the question from Ross about sort of pro-forming out. You talked about free cash flow and net income being equal, which is great, but we kind of have the pro-forma out this reserve but wondering over kind of what period of time we should be doing that?

We went all the way back. We don't have that many claims prior to -- most things are closed out prior to roughly 2003, 2004 other than maybe one or two claims that are just sitting out there and that's just process bid. But for the most part, we took -- we went back to every claim that's ever been open.

So we're going back a long way?

Long time. Yes, [into the 90s].

You guys have been at good returning capital to shareholders. But ultimately if you look, that's kind of $109 million, you could argue that $80 million of that you used to return to shareholders should have been -- in hindsight would have been -- should have gone into reserves.

Yes. And that's why it's been very important for me over the last couple of years to get this right, so on a go-forward basis, we can have confidence that all the pieces in the model as the models have to grow up are working as they should be and that the future itself doesn't point us back into another corner.

Scott Redmond, Redmond Asset Management.

Could you all be charging more and should you be exiting PEO services in certain businesses?

We are very, very rigid about how we underwrite and there are sectors of business that we don't see business with today that we did business back with in 2006, 2007. We look at today, we have no business that's -- no clients that's more than I think half a percent of our total book and we have concentration wise, I think our largest industry might be 1%, 2% tops. In fact, our largest fee code or code that designates where employees are working is 8810 which is office clerical and that's over 22%, 23%. So we continue to look at our book and look at where we're taking risk that we shouldn't be or where we shouldn't be doing business and keep moving the model to get to a better place there.

As far as being able to increase pricing and do different things, one of the things that -- one of the advantages we have in the market is that if you were to go back to 2008, 2009 and maybe even as early as 2010, we were seeing much more as a workers' comp company. I think in the market today, when -- if you were to go back, more and more of our clients, in fact I would almost get to say as much as 50% to 60% of our clients would say that workers' comp is a portion of the value proposition but the real value proposition is through the consultative offering that we have. And our job over the next several years and actually over the next year if things continue to -- as we continue to mature what we're doing is to dilute that value proposition away from being workers' comp specific and make sure that we're doing business with well-run companies for the sake of their true value proposition, which is more of a consultative interface that we have with our clients.

I'd just say that many areas that -- we do business in California, those businesses are much better than California as a whole. And it's really not, it's about not bad business or pricing.

I'd just say that many areas that we do business in California, those businesses are much better than California as a whole. And it's really not, it's about not bad business or pricing.

And then one of the things we've noticed is that the -- you have your costs associated with claims, but then there is also a loss cost multiplier relating to servicing those claims and get them closed and that from what we've seen has gone up 30% in the last -- since 2010. Is that a meaningful portion of your increase?

That increased some of the workers' comp expense and a lot of that is just in growing our claim management teams as we have continued to grow and to make sure that they are right-sized and that we remained in front of the curve with that structure.

One of the things that we also related to those costs is just as we have scaled our infrastructure to support a bigger company, we've gotten out in front of that, and that creates an acceleration to those cost structures, but over time as we're gaining more efficiency with technology and just reaching a point of critical mass where we'll find whether those costs and expenses will start to lever themselves a little more effectively as well.

Charles Bellows, White Pine Capital.

I guess just to make it simple for me is, are you going to have to be able or how much can you raise your rates on workers' comp and get that going and then where do you sit competitively, especially in California for that?

We were looking at -- over the last -- since 2011 just looking at where we were then relative to where we are now in markup percentage and whether it's half or whether it's the full value of the offering, we've increased our markup percentage by on an aggregate approximately about 100 basis points to 125 basis points. We've been going through a process of making adjustments where it's appropriate with our clients. And in the most recent quarters -- and that's to accommodate the ACE transition and because of the value proposition that we're offering, we've not seen headwind, in fact, I don't know that we've -- there's a few clients that you're going to lose and that's okay, that means you're at least getting closer to the market, and you're stressing it a little bit, but that number is not accelerating the number of clients that we're losing, and we are capturing that and in fact we're not seeing headwinds as it relates to increasing prices recently. And right now, our target is to pick up another 20 basis points to 30 basis points over the next year.

Thank you. That concludes our question-and-answer session. I would like to turn the call back over to Mr. Elich for closing remarks.

Again, thank you for being on the call. I know we've been on quite a while and I appreciate everybody's interest in continuing to understand and learn more about what we're doing. I wish with hindsight that we never had to have any disruption as we've had to grow up as an organization and but unfortunately, that's a lot of times not the case when you are doing something that's not been done before. And with each turn of the wheel, the model gets better and we're committed to making it better. I do feel that we've turned the corner. When I look back over the last four years as we've been realigning the entire organization in all aspects, and the retooling the business model, we had a lot of areas that we had to address. And with this latest move today, I do feel that we've cleared the deck and that we're in pretty good shape.

We're not going to be perfect moving forward. We're going to make mistakes. But we have a real strong infrastructure, great people, great teams that are committed to where we're going. And I've a lot of confidence from where I sit today that we're going to continue on and the model looks really good. So, I appreciate your time. I'll look forward to seeing in the street and I'll talk to you next quarter. Thank you.

Thank you, everyone. That does conclude today's conference. We thank you for your participation.