Barrett Business Services Inc (BBSI) 2017 Q3 法說會逐字稿

Good day, everyone, and thank you for participating in today's conference call to discuss BBSI's financial results for the third quarter ended September 30, 2017. Joining us today are BBSI's President and CEO, Mr. Michael Elich; and the company's CFO, Mr. Gary Kramer. Following their remarks, we'll open the call for your questions.

Before we go further, please take note of the company's safe harbor statement within the meaning of the Private Securities Litigation Reform Act of 1995. The statement provides important cautions regarding forward-looking statements. The company's remarks during today's conference will include forward-looking statements. These statements, along with other information presented that does not reflect historical fact, 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 to 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 December 8, 2017, starting at 3:00 p.m., Eastern Standard Time this afternoon. A webcast replay will 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 Chief Financial Officer of BBSI, Mr. Gary Kramer. Please go ahead, sir.

Thank you, Shannon. Depending upon where you're dialing in from, good morning or good afternoon, everyone. The operations of the company continue to be strong, which resulted in record earnings this quarter. Diluted income per share was a record $1.96 compared to $1.38 in Q3 '16. Net revenue of $240.1 million increased 7% compared to Q3 '16.

Gross revenue of $1.4 billion grew 11% over the same period. The third quarter of 2017 had 1 less work day when compared to the third quarter of 2016. When adjusting for a 1-day difference, our gross revenue increased by 13% over the prior-year period.

In the quarter, PEO gross revenue increased 12% to $1.33 billion compared to the third quarter last year and same customer sales grew by 5.9%. However, adjusting for the 1-day difference, same customer sales growth would have been 8.4% and was in line with our expectation. We continue to consistently increase our client base with a gross addition of 281 clients or 169 net of runoff in the quarter.

Staffing revenue in the third quarter decreased 11% to $42.7 million. This decrease was greater than we expected and is a direct result in the continued tight labor market. Each quarter, we discussed that this trend is making it difficult for our clients to hire, and we are experiencing this effect in our staffing business. We have the demand and orders from our client, but it is challenging to fulfill all orders without compromising our hiring standards. As such, we are expecting that staffing will now be a slight headwind to near-term revenue growth.

Workers' compensation expense as a percentage of gross revenue increased to 4.9% this quarter, which is at the low end of our expected range of 4.9% to 5.1%. Claim development on prior year was slightly better than expected, and the selection by our outside independent actuary resulted in a $300,000 favorable change in estimate.

As previously discussed, we have chosen to have a quarterly independent actuarial evaluation, which provides greater overall confidence in the adequacy of our reserve. The costs associated with administering insurance program were also lower in the quarter and this is a continued result of our efforts to pay heightened attention to the structure of our insurance program and our insurance operation. Our workers' compensation claim frequency continued to improve as we experienced a decline in the relative frequency of claims reported. Our total open claims at Q3 '17 grew 3% from open claims at 3Q '16 while gross revenue grew 11% for the same period.

In the quarter, we saw trailing 12-month relative frequency of claims as a percentage of payroll increase 1% compared to the third quarter of 2016 and decreased 16% compared to the third quarter of 2015. Our strategy to reduce frequency was initiated in 2014 and has been successful over the last 3 years.

Gross margin was $54.9 million or 4% of total gross revenue compared to $49.6 million or 4% in the prior year quarter. The fee we charge our clients remain constant, and the gross margin is in line with our expectations.

SG&A in the third quarter was $33.9 million or 2.5% of gross revenue compared to $30.4 million or 2.5% in the prior year quarter. We have made investments to support growth in the field, and we have built out our corporate groups to scale with our growth. We have added a deeper bench in accounting, internal audit and IT as well as with external partners. In the future, we expect to see this increased spend gradually decline as we gain leverage from our build in the field and in our corporate operation.

Nonrecurring expenses associated with accounting and security law issues in the quarter were $200,000 compared to nonrecurring expenses of $1.7 million in the prior year quarter. The provision for income taxes in the third quarter was $6.7 million with an expected annual tax rate of 32.9%.

We had no borrowings under our line of credit with Wells Fargo as of 9/30/17. We continue to be debt-free, except for the $4.4 million mortgage on our corporate headquarters in Vancouver, Washington. $4.2 million of this mortgage is classified as long-term liability as it is due in Q3 of 2022.

At September 30, 2017, we had cash, cash equivalent, investments and restricted securities totaling $409.5 million compared to $358.3 million at December 31, 2016. The unrestricted cash position in the third quarter increased to $35.6 million from $17.9 million in the second quarter.

The third and fourth quarters are typically our most profitable quarters and where we experience a build in unrestricted cash. As part of our funded workers' compensation insurance program with Chubb, we established and funded a trust account called the Chubb trust. On the balance sheet, the Chubb trust is included in restricted cash and investments. The balance in the Chubb trust was $358.4 million at September 30, 2017, and $277.1 million at December 31, 2016.

The trust is now fully invested with a fixed income asset liability matching strategy targeting a duration of 3.5 years. At September 30, the book yield was 210 basis points with a duration of 3.4 years. The trust has eligible security guidelines with restrictions on asset class and asset diversification. This is a high quality and highly liquid portfolio.

At 9/30/17, the average quality of the portfolio was AA and no investment was greater than 4% of the portfolio. In the quarter, we earned $1.5 million of investment income from the trust. The trust will continue to grow as BBSI grows and we believe will result in a greater return on the assets with low risk to the company. We will release our 10-Q later today, and I would like to provide an update on the progress we are making with our remediation plan.

We have one remaining deficiency regarding IT controls. I continue to be pleased with the progress we have made thus far, and I'm confident that we have a plan in place to be completely remediated by the end of the year.

In summary, we had record earnings in the quarter and grew our unrestricted cash while returning $0.25 a share to shareholders via the quarterly dividend. Our pipeline remains strong and we continue to build our base of net new clients. Our referral relationships are deep, and our distribution channel continues to widen.

Now moving to our outlook. For the full year 2017, we are reconfirming our expectation of diluted earnings per share to be approximately $3.10. This continues to assume approximately $0.13 per diluted share in estimated cost associated with accounting of security law issues as well as the return to an effective tax rate of approximately 32.9% compared to 26.5% in 2016. With a slight headwind in staffing and the continuation of tightening labor market, we expect growth in gross revenue over the next rolling 12-month period to be approximately 14%, down from our prior estimate of 15%.

During this quarter, we're finalizing our plan for 2018 and we'll provide full year 2018 guidance in our fourth quarter earnings release.

Now I'd 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 as well as our operational outlook for the remainder of the year. Mike?

Hello, and thank you for taking time to be on the call. Before I move on to a discussion about the quarter, I'd like to highlight a few areas of note.

As I do every year at the end of third quarter, I recently spent time in the field getting perspective on the business, guiding the organization and looking towards 2018. From this experience, I'm seeing continued maturation of talent in our team, alignment around our vision and consistency in our approach regardless of geography.

In addition to meeting with our teams, I've also had opportunities to meet with a number of clients and referral partners in recent months. As a result, I'm getting consistent feedback from our clients and partners as to the value our teams are delivering. Additionally, my experience in the field gives me confidence in the organization and our ability to bring value to our business owners, which should translate into long-term relevance and future shareholder value.

Looking at the quarter, we saw solid results and the fundamental of the business remains strong. We added 281 new PEO clients. We experienced attrition of 112 clients, 2 due to accounts receivables, 8 for lack of tier progression, 4 were canceled due to risk profile, 9 businesses sold, 24 businesses closed and 65 left to price competition or companies that have moved away from the outsource model. This represents an approximate build in our quarter of 169 net new clients, which is in line with expectation.

We saw same customer sale of 5.9%. As Gary mentioned, this was affected by having one less work day in the quarter than we had seen in third quarter of 2016.

Related to pipeline, we continue to evolve our ability to scale from a model based on individual market contribution to a systemic approach from developing -- for developing referral channels. As a result, today, we are seeing development in new referral channels in all markets which supports strong pipeline growth.

Year-to-date, we have seen contribution to pipeline from a significantly larger base of referral partners. Because of this, we are seeing consistent contribution to new business from all markets. Our ability to expand pipeline and consistently add to our client base in all markets gives me confidence in our ability to move into new markets and support growth against the large numbers.

Related to organizational structure, we have operationalized our approach to developing leadership and have roughly 18 months of runway with our existing bench. We continue to build the field organization to support future growth, scale into new markets and invest into support of our product offering.

Currently, we have 99 business teams supporting -- typically housed out of 57 locations. At the end of 2017, we anticipate having more than 102 business teams housed in 60 physical locations.

Related to branch stratification, we now have 17 mature branches with run rate in excess of $100 million. This is the measure we used to identify branches with the ability to increase leverage. We have 14 emerging branches that are running between $30 million and $100 million in gross revenue. We regularly reinvest back into these teams to support capacity as they grow. Finally, we have 26 branches we consider developing with run rates of up to $30 million in gross revenue. In these branches, we invest to support consistency of pipeline while maintaining integrity of product as they scale.

Looking forward, as I mentioned, this time of year affords me the opportunity to spend time in the field meeting with our teams as well as business owners from our client companies and our referral partners. This combined exposure to clients and our teams gives me visibility into what we are accomplishing. Our teams continue to mature and they are focused on the right thing. Our leadership bench continues to expand. Our value proposition is meaningful to business owners, and the model is portable and scalable. These factors support ongoing relevance of the offering, which allows for expansion of brand and markets while leveraging our existing infrastructure, all of which gives me renewed confidence that our continued focus will result in our goal, which is to increase shareholder value.

With that, I'll open it up for questions.

(Operator Instructions) We first go to Chris Moore with CJS Securities.

Maybe just start with the 14% ruling guidance on non-GAAP gross revenue. Can you at least provide maybe a rough breakdown between how you see that shaking out between same-store growth and branch less client expansion?

Thanks for the question. It's Kramer here. In the third quarter, we did see the headwind to our staffing business, and that was a function of there's demand out there but we were having a difficult time with our hiring standards to find available employees to fill those spots. And we expect that we're going to have a similar headwind for staffing in the fourth quarter and to continue on into 2018 as well. Based upon that, we would say, all right, we're going to have a headwind to staffing. We're going to continue to build out the branches and we're continue to add branches, which Mike talked about. We're going to add -- aiming for 3 in the fourth quarter. And when we take same-store sales, which we think is going to be comparable to historical averages, those 3 get us to the 14% revenue growth over the next rolling 12.

Got it. Okay. The 169 net new clients, can you kind of break that down roughly geographically or most of them or nearly all of them California? Are you seeing much strength in markets like Baltimore?

Yes, we're -- on a percentage of just base of growth, we're seeing consistency across pretty much all markets right now. We're seeing consistency in growth in -- from the East Coast, the Mountain States has been strong, even in Northwest. If anything, California is probably more -- in particular, Southern California has been maybe a little bit of a headwind to growth but -- on ads. But the one thing about the third quarter that's a little bit tricky is that, and I've watched this for years, it seems as though the better the economy is doing, the more time people take off during the winter -- or during the summer months and that includes probably late July, August and then early September. And I used to think that it was just that we would lose our focus, but what we're really kind of understanding more about it is that in the third quarter, it's difficult sometimes to get to settle down the business owner, your referral channels, keep them focused and get them to make decisions. So we typically always see the most volatility in -- of ads in the third quarter simply because you've got about 6- to 8-week period in there where there's just a little bit lack of focus. And then the model is always that you watch for the recovery as you come through September then to October and then as you round out towards the end of the year.

Got it, got it. Maybe just switch to workers' comp for a second. Obviously, the 4.9% looked -- a great number for the quarter. If -- my understanding is roughly 80% of your clients use workers' comp for you. So a few questions there. As you expand into new markets, any reason to think that percentage will change? California is a very litigious market. Is that percentage likely to kind of stay reasonably smooth as you move out into new markets?

Yes, we -- the comp is one of the products that we offer and we don't see that changing as we expand in geographies. I mean, the glory of the model that we have now with the Chubb program is that pretty much any market we go in where comp is available, we have that ability. So it's not what we try to lead with but it's a product that we offer.

Got it. And leading to that, I mean from a client standpoint, do you think that the percentage of clients today versus a couple of years ago, do they view workers' comp any different? I mean, say, 3 years ago, was workers' comp a must have for higher percentage of your clients than it is today?

Yes, absolutely. I think one of the steps that I threw out to the organization on at least an annual basis, and probably even more frequently than that, would be is if we did not have comp in our offering, how much business would we lose. If I asked that question back in 2012, 2013, it would have been probably north of 90%. Today, when I ask that same question, it's probably closer to 1/3. And the idea is as we are continuing to mature, our teams -- mature infrastructure that we get that number below 10%.

Next question comes from Jeff Martin with Roth Capital Partners.

Mike, I was curious if could expand on your comments regarding some of the new channels that -- or new client additions that you're seeing out there. And you talked about referral partners, you recently connected with them. Was curious if you could give some detail surrounding what you're thinking today and how that compares with a year or 2 ago?

So one of the things that we've always done is we get our pipeline of new business through referral channels, probably 90% or our -- 90%, 95% of our business comes from some sort of referral, whether it's a partner that is a trusted adviser to the small business owner that we might pay to bring us those opportunities, whether it's anywhere from your insurance broker, to your financial planner, to your accountant, to your attorney, that's always been the basis to how we've grown up. We actually are getting an increasing number of referrals from existing clients as well. So -- but when we look at the, I'll call it, the professional referral source that we use, one of the things that we discovered a couple of years ago was that we were creating a 1-to-1 relationship where if a branch was working with a referral channel, that relationship was somewhat finite to that those 2 individuals working an individual market. What we realized was that typically, that individual that was referring us business had a much broader footprint and could impact a larger geography for us. So a couple of years ago, probably it was August of '15, we started to back up a little bit and looked at kind of a lot of large numbers then wondered if we could -- if we did shift out a little bit, would we end up having a problem with the consistency of our pipeline and were we optimizing the relationships we had. So we started, at the time, bringing in our referral channels to really educate them more about who we are and what we're about. And with the intent with creating alignment between our value proposition as it is today versus what it might have been in the past. As we've done that now, we have a full algorithm that brings -- that is scheduled to, next year, bring through close to 300 individual referral partner or referral channels that we have with the intent of getting to know them better, help them to see our business through the eyes of how they're running their own business. And as we're doing that, we're seeing a lot of leverage and a lot of reaffirmation of, one, the value proposition and then the client. The individual referral partners, too, are taking a harder look at their business, how they're running their business and how they can use us to scale and build out and leverage their business. The other thing we're doing, too, that we're getting a lot of traction here, we've always been, and have grown up, is somewhat isolated by region or even by branch. And by taking a more global perspective, we're finding that where we have now interfaced with larger players that could -- can refer us business that we're now looking across large regions or even a super regional be it the East Coast or the western third of the United States. So we're starting to create pipelines that are much larger and we're having that 1-to-many relationships where when we have that relationship with that one that referral partner, they can pipe more business to us because the one individual might have contacts that might be 100 to 1 multiplier within their own organization.

Okay. And then can we dive into same-store sales growth a little bit? More -- pricing is relatively stable. What are the bigger drivers of a 6% to 8% same-store sales growth rate?

So I'll let Gary talk about the numbers. But what I'll say is if we look back -- it's hard to look forward in the mix. But when we look back over where we were a year ago compared to what we've been pushing up against in the last 12 months, prior to the election, we saw where -- business owners were not hiring people but they were -- as easily and we price our headwind to labor adds then. But what we saw was they were making it up through increased hours worked. So when we go back and look at a churn, we can see that our average hours worked were somewhere between 40 and 41 hours a year ago. And I believe it was more of a -- the idea of the risk associated with maybe election results leading in. So why would I build infrastructure if I didn't know where I was going to end up? It was after the election that we saw hours drop almost by -- well, they dropped from 40, 41 hours down to like 38. So that was the first impact to where we saw same-store sales soften. The other thing that we did see was that wages had not really moved yet, which would be a counterbalance to a tight labor market. And in the last year, what we've done is we have noticed and seen that wage inflation has gone up probably $1 an hour. So if we were running about $24.5 to $25 an hour 6 months to a years ago, we're pushing now $25.50, maybe even $26 an hour. So you're seeing some wage inflation. And now, what we're starting to see is with fewer hours worked, we're starting to see a rebound where you do have built in headcount but it's slower. So if we're kind of working off our averages that we've used in the past, say in a real robust economy where you've got -- it's easy to find people, you've got stability in hours worked, you've got stability in wage base, we were pushing 9%, 10%, 11%, 12% a quarter sometimes in same-store sales growth. Today, when we ratchet it back, we're kind of looking at more of a band of call it 6% to 8% in that world just because right now, there's not -- it's difficult -- the visibility of what the first and second quarter of next year will be from a same-store growth is probably the cloudier one. And so we're kind of left to offset that with how we're building and stacking into our pipe.

Yes, Jeff. It's Kramer. When we look at the, call it, the next rolling 12, in the fourth quarter, we're going against a softer comp. And then in the first quarter, we're going against a softer comp as well. And then that's really where, in the fourth quarter of '16, is where we saw the same customers drop to lows and then it continued into the first quarter. So when we look at our rolling 12 going forward, we said, all right, well, historically, we feel pretty comfortable at the 6% to 8% range. And then if you take that and put it over a softer comp, we feel pretty good about the rolling 14% revenue growth.

Got it. Okay. And then any expected changes that are material in the payroll taxes or other areas of taxes that may move the needle on margins next year? California budget goes into play here shortly and I think progress there.

Yes, I mean, we -- obviously we watch the pseudo caps and we haven't seen that the caps are not rising or staying with wage inflation. So that's actually a benefit to us in the industry. And for what we've seen so far, we don't see anything drastic regarding if the rates or the limits are going to go up going into 2018. So from a payroll tax, I think it's going to be pretty consistent with what we have for 2017.

Okay. And then last question, probably for Mike, is how has the competitive dynamic changed in your larger markets over the past year?

From when I look at our peer PEO market, we still don't see a clear direct competitor. So we show up, as we do and as we're built to, we're not seeing we're losing business to that. But what we have seen is in the comp market, the workers' comp portion of that business over the last few years, there's been a lot of pricing pressure there and there's been a lot of softness in the world of workers' comp. We have not given into that and we won't. And so we'll probably run up a little bit against that in the last probably year or so. But one of the things we've also been able to do is test our brand against that. So -- and we're not seeing we're having an adverse development in that work in that area. When I look at even businesses that would leave poor pricing for competitive reasons, that number still is probably less than 2% of the overall runoff in our overall book based on larger numbers. So we feel pretty good about that and I don't know that I'd want to -- I don't think I want to ever get it to 0 because if that was the case, then we probably wouldn't be charging enough for what we could.

(Operator Instructions) We next move to Bill Dezellem with Tieton Capital.

It's Tieton Capital. And relative to the commentary about the price and hours worked, if you said it, I missed what your existing client employment rate of growth or change has been. Would you -- either share that or circle back to it, if you've already said it?

Bill, it's Kramer. Could you qualify that question a little more? Is that regarding gross or employee growth?

Existing clients' employment growth or change.

That gets calculated in our same customer sales number. So the same customer sales is kind of 3 factors, it's did they add more employees, are they paying a higher rate or are the employees working more hours? And that all gets wrapped into the numbers we gave for the quarter, which, on the calendar, it was 5.4% or 5.9%. But if you look at it with an extra day, it's about an 8.4% growth over prior quarter.

Yes, where it gets a little cloudy, Bill, on that one is that you still have wage inflation contributing to that -- some degree to that number, and then you have -- hours worked has been pretty stable. So probably looking at the majority of that ad, maybe even price 70%, 80% of that has been from client stack. The challenge with it a little bit is that only includes clients that have been with us more than a year because you're using period-over-period comp. That doesn't count the clients that have come on in the recent year. But it's probably if we're saying 8% same stores growth, it's probably close to 5%. There's a little bit of slag.

Right, so 3%.

3% would be inflation.

Right. And since hours worked are roughly flat, then that puts the remainder for the employment?

Yes, that's kind of how you back into it.

Great. That's quite helpful. And then a couple of numbers questions that I apologize for not understanding this more clearly, but the direct payroll cost were down on an absolute basis to $32 million versus $37 million last year on revenue growth. I don't understand that. Would you help clarify how that happened?

So the payroll is really on a gross -- are you looking at the gross or the net, Bill?

I'm looking at the -- would be the net on the full income statement that you published. I believe it's the last. It is the last item you published in the press release.

Yes, this is why we look at our book on a gross basis because when you're looking it on a net basis, staffing distorts the net. It's a small piece of the book as far as our portfolio but it's actually a larger piece of the net. So that's why we look and we measure our book on a gross basis. So when you look at staffing going down by 10%, that's where it's distorting you on a net basis. But if you look at the payroll to gross revenue on a gross basis, it's in line with where we think it should be.

Okay. I would still be confused though because the gross revenues did go up and yet, the direct payroll cost went down. What is it that I'm missing there?

That's the staffing. It's -- and I can walk you through it off-line but the -- with staffing going down on the net basis, that has a direct effect to the payroll. Because on the net basis, the payroll cost for our PEO clients don't go through payroll, right? So that's why we have it on the gross basis so that they go into payroll and they go into gross revenue.

That's helpful, Gary. And workers' comp also declined as a percent of your PEO revenues versus the Q2 and versus the Q3, and here I am looking on a net basis and so maybe this is a net gross phenomenon. But would you describe or help me understand the ins and outs of how that happened?

Yes, the workers' comp was a, I'll say, a laser-focus effort to try to minimize the cost. We had a small favorable development that came out of the study, which was $300,000. But really, what we do is we continually look at our workers' comp and try to figure out better ways to which to manage the cost, to manage the expenses and manage the structure that goes with it. So what we're really starting to see is, I'll say, a concerted effort to try to have a -- to try to get that comp expense down to the lower end part of the range.

So if I may infer something you didn't actually say but maybe you were implying that you had a real, like you said, laser focus on this. And as a result, you were successful this quarter. You wouldn't want us to incorporate that too far into our forward thinking. However, if you're able to continue to be successful, you may be directionally moving that workers' comp down as a percentage of the PEO revenue.

Yes, we have the intent and the focus to try to drive that cost down just like we do everything in our business. The idea there is to try to bring as much value to shareholders as possible. And if we can control expenses or structures and costs, we're going to look at every opportunity to do that.

Yes, Bill, I would also add is that as we were building out the program with Chubb over the last several years, we were kind of establishing a new normal, we'll call it. And now, we're getting to the point where, and especially with Gary's expertise, we're just finding areas where we can bring efficiencies back to the program.

At this time, this concludes our question-and-answer session. I'd now like to turn the call back over to Mr. Elich for closing remarks.

Thank you for joining us for the call. Again, very pleased with the quarter, pleased with what we're getting done. Looking forward to joining you all in the call again in February as we announce the close of the year and the close of the fourth quarter. Thank you.

Thank you, ladies and gentlemen. That does conclude today's conference. We thank you for your participation, and you may now disconnect.