Coming off a stock market that lost almost 40%, the rational investor has sold first and asked questions later, particularly with cyclical names. I argue that it is now time to start asking some questions and look for names that may be oversold. Names where a little bit of work can reveal a compelling risk reward opportunity.
One such name, in my opinion, is Gevity HR (GVHR). Gevity lost over 80% of its value in 2008, with almost all of the loss coming in the last 3 months. It is currently trading for $1.60 per share giving it a market capitalization of $32M. It is priced for a complete wipeout of the equity holders; I do not think this is likely based on their balance sheet which has a $122M hidden asset in the form of over collateralized workers compensation insurance plans.
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Investor concern and skepticism for Gevity is well founded. It is a cyclical company with overweight exposure to the Florida economy. The following description is from Reuters:
Gevity specializes in providing small- and medium-sized businesses nationwide with a range of payroll, insurance and human resource (HR) outsourcing services. Gevity is a professional employer organization (PEO), which means that the company provides certain HR-related services and functions for clients under what is referred to as a co-employment arrangement. Under the co-employment arrangement, Gevity assumes certain HR/employment-related responsibilities, as provided for by a professional services agreement (PSA) and as may be required under certain state laws. The core services typically provided by a PEO are payroll processing, access to health and welfare benefits and workers' compensation coverage. In addition to these core offerings, the company's Gevity Edge PEO solution provides HR services, such as employee retention programs, new hire support, employment practices liability insurance coverage and performance management programs. Gevity has field-based HR Consultants.
In essence, Gevity allows a small business to offer benefits packages that are comparable to a Fortune 500 company's with Gevity assuming the administrative details for a modest monthly cost. Their average customer is a small business with 17 employees and pays $97 per employee per month. Their typical customer comes from a large payroll company such as Paychex or ADP that charge roughly $50 per employee per month for payroll processing – so the net cost for the access to benefits is $47 per employee per month. In some instances, Gevity is able to save their customers enough on workers compensation and health insurance to more than offset the price difference between Gevity and a traditional payroll processor such as ADP, and the employer can truly offer more for less.
HIDDEN VALUE 3X THE CURRENT SHARE PRICE
As part of their strategy to offer savings on workers compensation insurance, Gevity is self insured for the first $1M in losses on each claim. As a result, the company puts up collateral for a period of seven years with their worker’s compensation insurance provider, AIG. Each year, an evaluation is made of the claims to date and likelihood of future claims and adjustments are made to the required collateral. Currently Gevity is over-collateralized by $122M or $4.80 per share (over 3.5x the current share price).
The following is from their last 10K:
As of December 31, 2007, we have a workers' compensation receivable from AIG of approximately $122.3 million for premium payments made to AIG for program years 2000- 2007 in excess of the present value of the estimated claims liability and the related accrued interest receivable on those payments.
The company does an excellent job of breaking out the over collateralization by year, as well as the number of outstanding claims. As long as the company continues to operate, there will be a level of over collateralization, so the full $122M will not be returned to shareholders. However, as their levels of claims continue to decline, the amount of required collateral should decrease, providing a return of cash to the shareholders. It is also very important to note that this asset can be sold. In this environment, the company would take a haircut, but this asset is very good protection against bankruptcy wiping out the equity. It could also be the source of financing in the event of a buyout.
The private equity firm, General Atlantic Partners, purchased 10% of Gevity on the open market earlier this year at an average price of over $4 per share, with the stated intent of pursuing a strategic combination with their own private PEO, Trinet.
At the current share price, Gevity is valued with an Enterprise Value/client employee of less than $500 per client employee. Each client employee generates approximately $97 per month in service fees. Even at 3X the current share price, General Atlantic has a compelling buy vs. build opportunity with Gevity. They would be purchasing client employees at less than $1500 per client employee – or less than 1X annualized service fees and should be able to expand margins through economies of scale. All of this could be financed through the liquidation of the workers compensation receivable.
The same logic would hold for other strategic acquirers such as ADP and Paychex which have small PEO operations.
MANAGEMENT AND SHAREHOLDERS' INTERESTS MAY NOT BE ALIGNED
Given the new tenure and minute equity holdings of the management team, their incentives may not be aligned with the common share holders. The company has not been actively courting the investment community and trying to increase the share price. It would be rational from a personal gain perspective for management to focus on selling the company to a strategic acquirer and securing equity and an operating role in the new entity. Realistically management could secure a larger equity stake at a very low valuation in a private equity transaction.
One logical scenario would be for management and the two largest shareholders to take Gevity private and then merge it with General Atlantic’s own PEO TriNet. The deal would have 25% of outstanding shares and management backing it. At current prices, down 85% for the year, a large premium to current share prices would be required, and provides attractive upside at current prices.
Counterparty Risk: There is some counterparty risk on the workers compensation receivable, as AIG is the counterparty. I take comfort in the fact the government has currently deemed AIG too big to fail, and the fact that as I understand it AIG issues are at the parent company, and that the state regulated subsidiaries are sufficiently capitalized and not at risk.
Lack of Organic Growth: Gevity has not been successful at generating any organic growth in the last five years. Given the current jobs environment, generating organic growth will be even more challenging.
Gevity has gone through management changes and product changes. Their two largest challenges in the past two years have been sales leadership and non competitive health insurance rates. There was a disastrous decision to make the CFO the head of sales. This lasted less than a year. Not surprisingly, the individual had trouble making the transition. Gevity sales team is now led by a veteran from IBM and the company is actively hiring sales reps from other PEOs. Interviews with sales reps in the North East indicate that there is a dramatic improvement in the quality of the sales force as well as the support from the central team in FL.
In the last earnings press release, the company also cited strength in sales:
For the third quarter, the Company continued its selling momentum by generating a 29% sequential increase in quarterly sales production over the second quarter. Additionally, the number of client-initiated terminations declined for the third consecutive quarter. The increased sales volume and lower client-initiated terminations were more than offset by a higher level of client employee attrition, which was principally driven by economic related conditions and seasonality among existing clients.
The second major change that the sell side has not picked up on is the importance of the company’s health insurance offering. For 2007, Gevity selected a series of non competitive health plans. At the time I was the CFO of a Gevity client. We saw our health insurance rates increase 25% without any commensurate increase in quality. In 2007, Gevity saw a 20% decline in the participation in their health insurance plan. For most of their clients, including myself, the plans Gevity offered went from being below market to above market. Gevity went from saving their clients money to costing them money.
As a result, clients either dropped out of the health insurance and kept Gevity for other benefits, or dropped Gevity entirely as I did. Their value proposition was dramatically muted. I went from paying $100 an employee per month for Gevity services but getting a $50 per month savings on health insurance – for a net cost of $50 (less than ADP) to paying the full freight of $100. The pricing issues combined with some idiosyncratic reporting requirements we had that Gevity could not fill forced us to leave. Not surprisingly, Gevity had historically high customer attrition in 2007 and weak sales production. Both of those issues are largely fixed with their new health insurance offerings.
Just focusing on the balance sheet, Gevity appears to be dramatically undervalued. The company ended the last quarter with a net debt of $20M and a current market capitalization of $32M for an enterprise value of $52M. Ignoring the earnings power of 6,000 customers paying almost 100,000 employees, the current valuation severely discounts the value of the workers compensation receivable of $122M.
Below is a chart comparing Gevity to Administaff, a similarly sized PEO. Administaff has better growth and a higher margin book of business, however this large a discount is not justified.
Given the management changes, product changes, and cyclical challenges facing Gevity, determining normalized earnings is challenging. In the past nine years, Gevity has made money in eight of them. In its best year it made 97 cents per share. There is operating leverage in the business and Gevity is at their low end of client employees.
Other factors to consider are the mix of client employees, average fees per employee which have improved. According to Capital IQ, Gevity’s average P/E for trailing normalized earnings is 15.5. I estimate that normalized earnings are in the 50 cent range. Assuming 50% of the historical average PE of 15.5 and applying that multiple to normalized earnings of 50 cents yields an intrinsic value of approximately $3.85 per share – or approximately three times the current share price.
Gevity is trading at a discount to its net assets, its peers and its historic multiples. Given the magnitude of the workers compensation receivable the company has, there is very little likelihood of bankruptcy. Thus Gevity provides a high margin of safety. For investors very bearish on employment, Gevity can be paired with any overvalued cyclical stock.