Barrett Business Services' (BBSI) CEO Mike Elich on Q2 2016 Results - Earnings Call Transcript

| About: Barrett Business (BBSI)

Barrett Business Services, Inc. (NASDAQ:BBSI)

Q2 2016 Results Earnings Conference Call

August 10, 2016, 12:00 PM ET

Executives

Tom Carley - Interim CFO

Mike Elich - President and CEO

Analysts

Jeff Martin - ROTH Capital Partners

Bill Dezellem - Tieton Capital Management

Richard Murphy - Cross River Capital Management

Patrick O'Keefe - Cloverdale Capital

Operator

Good morning and afternoon everyone, and thank you for participating in today's conference call to discuss BBSI's Financial Results for the Second Quarter Ended June 30th, 2016.

Joining us today are BBSI's President and CEO, Mr. Michael Elich; and the company's Interim CFO, Mr. Tom Carley. Following their remarks, we'll open the call for your 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 are -- 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 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 September 10th, 2016, starting at 3 P.M. 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 Chief Financial Officer of BBSI, Mr. Tom Carley. Sir, you may go ahead.

Tom Carley

Thank you, Rochelle. The operations of the company were strong in the second quarter of 2016 and we believe the results of the quarter represent a solid foundation on which to build.

Net revenues of $203.4 million in the second quarter of 2016 increased 12% from $182 million in the second quarter of 2015. Gross revenues of $1.1 billion grew 17% over the same period.

Diluted earnings per share were $1.16 in the second quarter of 2016 compared to $1.21 per share in the second quarter of 2015. The second quarter of 2016 included $0.24 per share of accounting and legal costs associated with financial restatements, outside investigations, and legal proceedings related to securities law issues.

In the second quarter of 2016, PEO gross revenues increased 19% to $1.1 billion compared to the second quarter of last year. Contributing to this growth were 266 net new PEO client additions and same-store sales growth of 8.7%.

These results are attributable to both ongoing efforts to further develop our referral relationships and the ability to of our teams to remain focused to delivering value to our clients.

Staffing revenues in the second quarter of 2016 declined 11% to $37.6 million compared to the year ago quarter. Given the continued labor shortage, we have chosen not to maintain or pursue client relationships that do not align with our model.

Gross margin in the second quarter 2016 was $42.3 million, or 20.8% of total net revenues compared to $36.5 million, or 20% in the year-ago quarter. Gross margin as a percentage of gross revenues in the second quarter of 2016 was 370 basis points compared to 375 basis points in the year ago quarter.

An increase in payroll and workers compensation expense as a percentage of gross revenues offset an improvement in payroll taxes by five basis points in the second quarter of 2016.

We continue to see a decline in relative frequency of workers' compensation claims. Our total open claims at June 30, 2016 grew 7% from open claims at June 30, 2015, while gross revenue grew 17% for the same period.

In the quarter, we saw a trailing 12-month relative frequency of claims as a percentage of payroll decrease 8% compared to the second quarter of 2015 and decrease 7% compared to the second quarter of 2014. Claims from 2012 and prior continue to show positive trending, which leads us to believe our efforts at strengthening have had the intended effect.

The significance of the 2012 and older claims is that they are now well seasoned and having been fully strengthened provide us with a solid basis for analyzing the development of claim years 2013, 2014, and 2015.

In the next 12 months, claims from 2013 will have had sufficient seasoning to provide a firm representation of the new normal, as it relates to loss development, claims closures, and strengthening.

SG&A expenses increased 33% to $28.5 million compared to the second quarter of 2015, in part to do -- in part due to $2.6 million in accounting and legal costs associated with financial restatements, outside investigations, and legal proceedings related to securities law issues. Higher branch level expenses, including management payroll to support our growth, also contributed to the increase.

Our effective tax rate in the second quarter of 2016 was 34.4%, down from 36.1% in the second quarter of 2015, due to the utilization of work opportunity tax credits in the second quarter of 2016. At June 30, 2016, we had cash, cash equivalents, marketable securities, and restricted securities totaling $296.7 million compared to $294.9 million at March 31st, 2016.

At June 30, 2016, we had $12.2 million in debt, including $7.5 million on our term loan with Wells Fargo, and a $4.7 million mortgage on our Vancouver, Washington headquarters. We had no borrowings under our line of credit with Wells Fargo as of June 30, 2016.

On June 30, 2016, we made a scheduled payment of $5 million to Wells Fargo. We will make another $5 million payment on September 30, 2016. We will pay the remaining $2.5 million of the December 31, 2016 payment on the earlier of either December 31, 2016 or upon receipt of our federal unemployment tax refunds.

As part of our fronted workers' compensation insurance program with ACE, which started in February of 2014, we fund a trust account called the ACE Trust. The balance in the ACE Trust was $232.9 million at June 30, 2016 and $190.2 million at March 31st, 2016. The ACE Trust is included in restricted cash equivalents and restricted marketable securities.

With respect to the NASDAQ listing status, we received written confirmation on July 7, 2016 that we are once again in compliance with NASDAQ listing standards. We are currently in a request for proposal process for auditing services for our 2016 financial statements and hope to have an announcement shortly.

As we introduced last year, in order to provide our investors with a more appropriate forward-looking view of our business, we have initiated a rolling 12-month outlook for gross revenues, which we plan to update on a quarterly basis. We continue to expect gross revenues for the next rolling 12-month period to increase approximately 18%.

We continue to expect 2016 diluted earnings per share of $3.50, which includes our estimate of $6.4 million, approximately $0.57 per fully diluted share for accounting and legal costs associated with financial restatements, outside investigations, and legal proceedings related to security law issues. We reported diluted earnings per share of $3.47 in 2015.

Now, I would like to turn the call over to our President and CEO of BBSI, Mike Elich, who will comment further on the recently completed 2016 second quarter as well as our outlook for the remainder of the year.

Mike Elich

Thank you, Tom. Good morning, and thank you for taking time to be on the call.

Before I move into discussions about the quarter, I'd like to highlight a few areas of note. In recent months, we conducted operational peer reviews with every member of our field leadership, providing a clear view into our branch strength. We hosted two significant events for our referrals partners, providing insight into the strength of our channel and brand.

We've spent time with several key structural partners and have a clear view into the partnerships that support our external bench. And finally, we conducted a nationwide search for a CFO to lead our financial and accounting team. We're pleased to introduce Gary Kramer, who started on August 1st as an employee and fills the role of CFO effective August 10th.

Moving forward, in the second quarter, we saw progress through growth and maturing of our brand in all markets. We also saw the strength of our organizational bench and culture of BBSI as we were tested. And we saw progress of several significant initiatives undertaken during the past several years.

In the quarter, we added 341 new PEO clients. We lost 75, two were due to accounts receivable issues, nine were due to lack of tier progression, 15 were cancelled due to risk profile, 14 businesses sold or closed, and 35 left to pricing or competition or companies that have moved away from an outsourcing model and taking peril in house. This represents an approximate net build in the quarter of 266 new PEO clients as we also saw same-store sales of 8.7% in the quarter.

Related to pipeline and regional growth, we saw more predictability and consistent activity in pipeline and new client growth as a result of focused efforts on our referral channel. We also brought more attention and visibility to the drivers supporting growth and retention.

We're now looking broad -- we're now seeing broader contribution to client growth from all regions, as a result of these efforts. We continue to see strong growth across all regions with the Northwest, East Coast and mountain states representing regions of particular growth as we continue to invest in these areas.

Related to structural and organizational build, as we move forward, we continue to build business units as needed to support current and future organizational and market demands. Currently, we have 49 business units, supported by 55 branches. We currently have eight business units in development, which will bring our total of 57 -- to a total of 57 by the end of 2016.

We now have 15 branches that have or will have reached the $100 million mark by the end of 2016, a measure we use to indicate a branch's ability to increase leverage and tipping point of our brand in those markets. We have two branches slated to open in late 2016 or early 2017 on the East Coast and in Southern California, which will bring our total branch count to 57.

Related to systems, as we recruit and develop stronger teams, we're focusing on systems -- we're focusing our systems on tools that will allow our teams' greater leverage. We believe our teams will need greater predictability to successfully stay ahead of our growth curve.

To that end, in the quarter, we have rolled out an operational dashboard we're calling 360 that will fully -- when fully implemented, will provide greater visibility into key metrics and bring greater predictability to our business.

Through upgrades in systems over the past six months, we have created a strong foundation for future growth. We continue to evolve to next generation technology platforms that complement how we look at the business and how we operate at different levels in the company.

We also continue to create stronger alignment between our vision, our approach to structure and the systems we develop to support our brand relevance over time.

Related to workers' compensation and the underwriting of risk, we continue to make progress in bringing predictability to the company's workers' compensation expense. Through our approach to running the company with -- and helping business owners to run better companies, we're seeing systemic improvements related to stronger cultural alignment with all disciplines during pipeline phases, which continues through the client relationship. Emphasis on continuous improvement and on root cause analysis as we interface with our clients, and focus on frequency as a controllable factor in claims expense.

Moving forward, we will continue to monitor trends in maintaining -- to maintain a proactive position related to workers' compensation. We expect this to continue to result in greater predictability within the model.

Looking at the remainder of 2016, tomorrow begins a new chapter for our Executive team and the company with the addition of Gary Kramer in the role of CFO. I'm grateful to Tom Carley, our Interim CFO and all he has contributed -- accomplished in recent months and for the leadership he provided the Financial and Accounting team. With the transition from Tom to Gary, we look forward to building a Finance department that supports our ongoing and future growth.

As I look at the organization today, I have evidence that many of the efforts we're undertaking in recent months have begun to have the intended effect. We're putting thought and resources into the organization we're building, with an emphasis on bringing predictability to the model. We have operationalized our approach to developing our leadership bench and have roughly 18 months runway.

We have brought a consistent approach to channel development, resulting in predictable pipelines and new client growth. And we have focused on systemic reduction of risk in our client's businesses resulting, in continued decrease in relative frequency and increases in predictability.

As an organization that seeks to help business owners navigate inflection points in our growth, we have the opportunity to learn from our clients' experiences as well as our own. We know there are elements of the business that will always need to be evaluated, as we grow. Today, we are executing on a plan that we have had -- that we have made critical -- and we have made critical steps towards migrating past our home plateaus and inflection points as we grow.

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

Question-and-Answer Session

Operator

Thank you sir. The question-and-answer session will be conducted electronically. [Operator Instructions]

And we'll take our first question from Jeff Martin with ROTH Capital Partners. Please go ahead.

Jeff Martin

Thanks. Good morning Mike and Tom.

Mike Elich

Good morning Jeff.

Jeff Martin

Mike, could you speak to an 8% lower frequency of claims and a 7% claims growth year-over-year means to workers' comp expense going forward?

Mike Elich

Well, there's two factors. So, when we look at how we accrue for what we'll call our pick or our expected loss, we are building our accruals based on what our history has been. So, any time our frequency is reducing relative to what our history has been or relative to our growth, it means that we're actually -- we have fewer claims in the bucket relative to what we would have forecasted.

So, there's two factors. If you figure your accrual is what you're predicting or what you're forecasting, then frequency would be what adds up to the total actual cost over time. And then the only thing that's still out there that's an unknown would be severity of the claims that you actually have. But with the relative decrease in frequency, it means that you don't have as many claims as you would have ultimately accrued for.

Now, you won't know for a period of time or a longer period of time, maybe even up to two years -- two or three years whether or not you have the severity in that pool to know whether -- where you're really at.

But when you look at frequency as a whole, it's the one predictable element of the business that if we can impact that, we know that we're putting ourselves on the right side of the line.

Jeff Martin

And do you have the number on how many claims 2012 and prior closed during the period and how many remain outstanding?

Mike Elich

I don't have that with me right now.

Jeff Martin

Okay. Tom, could you walk us through the sources and uses of cash in the quarter? It looked like working capital deficit increased a fair bit over the last six months, but could you talk specific to the quarter or the per six months or just uses of cash?

Tom Carley

Sure Jeff. One of the real drivers in our use of cash is the ACE Trust and we talked about the build in that. And the way that works is the current versus non-current portion of the ACE Trust is driven by the current and non-current portion of our workmen's comp reserve. And that's one of the prime movers in why we've got this working capital deficit.

The other issue we had this quarter is that the quarter ended on Thursday, which is our low point of cash for a week. If we had closed it on Friday, we would have had a significantly lower working capital deficit.

But the big use of the cash in the quarter were the build and the ACE Trust. We also paid off $7.5 million of the Wells Fargo term loan. So, those are the two big drivers.

Jeff Martin

Okay, great. And then Mike could you touch on growth in various geographies? I know that you had been seeing growth outside of California really picking up. Wondering -- you mentioned a little bit about it already, but maybe you could be a little more specific, what areas you're seeing and what investments in those areas you're making?

Mike Elich

So, overall, if I were to break it down, we saw topline -- and this is on a gross basis, roughly a 15.6% growth rate in California. In the Atlantic states, we saw 27% growth; in the mountain states, we saw close to 27% growth; and in the Northwest, we saw 30% growth. So, we continue to see strong drivers in the less mature markets, which are supporting the overall growth of 17% of topline gross revenue.

Jeff Martin

Okay, great. Thanks for taking my questions.

Operator

And next we move on to Bill Dezellem with Tieton Capital.

Bill Dezellem

Thank you. Would you help me understand something I'm a little confused about please? Workers' comp expense were up as a percentage of revenues in Q2 versus Q2 a year ago and yet you're having these favorable frequency and other trends within the workers' comp. It seems as though those -- the workers' comp expense should be trending also favorably or down. What am I missing in this whole process?

Mike Elich

The big driver, if you go to the 10-Q and you go to the workers' comp table, a year ago in our prior period claim expense accrual, we had a credit of $4.2 million and this year, it was only $1.4 million. So, that's why -- we said that the band is 4.90 to 5.0. The expense in Q2 a year ago was 4.92. This year was 4.99. So, both quarters within the band. We also trended down from 5.24, I think it was, for the first quarter. And we think that for the full year, it will be within the band of 4.9 to 5.0.

Tom Carley

Also Bill I would add that even though we're seeing the relative reduction of frequency, we don't get credits for that actuarial for a period of time.

Bill Dezellem

Very good point. And -- so, you do continue to have prior period claims credits that are benefiting you, which I guess is an indication of the conservativeness of the charge taken in 2014?

Mike Elich

Yes, one of the things we saw early on too after we took the charge, you saw more credits coming quicker as we had more claims closing quicker because we were closer to 2012. Now, you're going to see the remaining claims that are still open -- close slower for 2012 and prior. And therefore you're not going to see as many credits -- as much in credit. But we're still seeing credits coming out of those back years where we strengthened as well as current years 2013 and 2014.

Bill Dezellem

That's quite helpful. I would like to take this one step further if I may. The experience that you're having with the prior period claims being a bit better than originally assumed and having credits along with the fact that your frequency of claims -- your current frequency of claims is decreasing, what's the timing when those data points work into the actuarial models and begin to have an impact?

Mike Elich

It's one of those -- it's hard to predict, but it could still be as much as a year. And our goal right now is to run and continue to accrue and run, keep workers' comp at a level that doesn't take advantage of any improvement until we know we actually are seeing that. So, even though we're coming up on what would be two years since we took the charge, it typically would take three years to establish a new trend.

So, I would suspect that probably within the next 12 to 18 months, we should be able to start seeing that. But our focus today is to have predictability and consistency as much as anything, and then if we can -- if we are able to recognize an improvement over time, then that's a benefit.

Bill Dezellem

Thank you both. And Tom thank you for your stewardship over this last really difficult period.

Tom Carley

You're welcome Bill.

Operator

[Operator Instructions]

And next we'll move on to Rich Murphy with Cross River.

Richard Murphy

I wanted to ask a question on the charges. You give a per share number, you also give an absolute dollar number on the remaining charges for [Indiscernible] litigation. Is that -- how do I look at in the next two quarters in terms of what's left on an absolute dollar? And then given the share, does that fall into SG&A? I'm assuming it does.

Mike Elich

Yes, it's all in SG&A. I think the way you have to look at it is that the second quarter was the peak in terms of the accounting and legal. We had the Moss Adams' audit team of 20 here from April 1 to May 25th. We had the wrap-up of the PwC Forensic audit through April and into May. We had some consulting help from PwC's auditing arm. And we had the ongoing legal expenses associated with the SEC investigation, the class-action lawsuit.

So, I think the way you got to look at Q3 and Q4 is that the accounting piece of it is pretty much done. And now we're into legal expenses associated with the different issues that we're working through. And the way we look at it here, you never know until it's all wrapped up, but it's probably another $1 million in each of Q3 and Q4 for legal, maybe less, but that's our best cut at this point in time.

Richard Murphy

And then from -- just if you back that out, what is -- we always talked about having some nice operating leverage at the SG&A level. We haven't seen it some of these numbers, but is 24 [ph] kind of a high watermark, we should that started get back to the 2% to 2.25% of revenues or where does that kind of level out?

Mike Elich

I think if you strip out the legal and accounting, I think the way you got to look is, on a go-forward basis is, we're going to get more leverage at the branch level, which we really haven't gotten to date.

We continue to invest in business units, but that should be coming here fairly quickly. We've seen leverage in terms of corporate and the overhead. So, I think going forward, you're going to see some SG&A leverage if you strip out the legal and accounting.

Richard Murphy

Okay.

Tom Carley

One of the things that -- another way to look at it too is we have had -- once branches reach a certain level, they begin to lever is relative to their size, the SG&A that goes up against supporting that revenue is, we just start to lever the SG&A revenue for those individual branches.

If you were to look at the fact that we have 55 branches today going to 57, but we have 15 of them that are reaching that $100 million mark. Now you have, call it a third of your branches that are -- even 25%, 30% of your branches that are starting to reach a certain critical match that creates a tipping point.

If we were to increase that to a third to ultimately maybe 50% of all branches reaching that, the drag on your build branches is going to be less. And so that's another way to look at it as we get into 2017 and 2018.

Richard Murphy

And I would see that in -- from an income statement standpoint, where would I see that? Would we see the gross margin start to improve?

Tom Carley

You'd see it in -- from an operating margin standpoint.

Richard Murphy

Okay. Operating margin.

Mike Elich

The other thing to think about is I think the belief here is it's two to three years before a new employee really starts to contribute meaningfully. And you've a lot of these business partners out there in the business units that haven't been with us that long. And as they get more experience, we'll get more leverage out of them. And that's going to be a big driver going forward.

Richard Murphy

Okay. And that's -- so when I talk business units; that jump from 37 to 49 quarter-over-quarter, is that something that will be standard if we go? You'll start to see [Indiscernible] pop-up or is that going to come in?

Mike Elich

You'll probably see that kind of build, but on a -- relative to the base. The relative build will be less and you'll see it start to stabilize. The last couple of years, we went from zero to where we're at today and the next -- for the balance of this year and into 2017, you're going to add another right. Probably as we look at even 2017, you might add another eight to 10 in the entire year. So, the build in that area will start to temper itself relative to the overall size of the team.

Richard Murphy

Okay. And I can take this offline, but I have a hard time just like -- when we talk about those numbers, you're saying $3.50 is your guidance. So, the next two quarters, you want to factor in almost conservative numbers, it's hard to get to that number. I'm getting much higher than that number. Is there something in the back half that -- or are you just being conservative?

Mike Elich

No, I think we're -- we put [Indiscernible] in a spot that it's prudent to be conservative. And if you just consider the $3.50 number, it was a guide that we felt comfortable with, based on 18% growth rate and knowing the cost that we're -- the extraordinary cost that we're going to incur in the year. When we back those out, that's what led us to the $3.50 number. So, we're still comfortable with that number. I think that was a guide that we gave at the end of June. And just looking at the year, I think that's a number that we feel good with.

Richard Murphy

Okay. Well, give it a good work. It seems like the storm clouds have passed. So, look forward to the next couple of quarters. Talk to you guys soon.

Mike Elich

Thank you.

Tom Carley

Thanks.

Operator

And next we'll move on to Patrick O'Keefe with Cloverdale.

Patrick O'Keefe

Hey guys, congratulations on a great quarter.

Mike Elich

Thank you, Patrick.

Patrick O'Keefe

Yes. So, just going through the Q, I noticed in Note 8-Subsequent Events that two days ago, August 8, you received notification from the IRS about overpayment of federal unemployment taxes and it looks like roughly $2.6 million or so on 2013 and 2014?

Tom Carley

Yes.

Patrick O'Keefe

Is that a tax benefit that you would expect to recognize later this year?

Tom Carley

Yes.

Patrick O'Keefe

Okay. So, you'll be getting that cash at some point this year, right? And that's roughly $0.35 of earnings per share, right?

Tom Carley

I haven't done the calculation. You would tax effect it at a 34.5% effective tax rate, but yes. When the cash comes in, we'll recognize the contingent gain.

Patrick O'Keefe

Okay. And that will be reflected in the lower tax rate in the back half of the year, right?

Tom Carley

It's not income tax. It's FUTA, so that would be in the payroll tax expense line in the gross margin area.

Patrick O'Keefe

Got you. Okay, great, great. So, gross margins, you'll get some pretty nice leverage there. And then on that subject, given that it looks like you overpaid in 2013 and 2014 and you're filing an amendment for overpayment in 2015, is this something that's been kind of a systematic, where on a go-forward basis you might have a lower ongoing rate?

Tom Carley

That would be the assumption that we might make, but we're still really working on the analysis to understand exactly what that would be. And until we actually see -- have check in hand, we're not going to bank on anything.

Patrick O'Keefe

All right. That makes sense. Thanks very much guys.

Mike Elich

You're welcome.

Operator

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

Mike Elich

Again, thank you for being on the call and thank you for sticking with us over the last year or so as we've had to navigate ourselves through a bit of a storm. But I feel very good about where we're at today.

Gary -- you'll get to know Gary in the coming months, but I feel very good about him even after five days. And looking forward to a great future as we continue to execute on our plan. Thank you.

Operator

And that will conclude today's call. We thank you for your participation.

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