TriNet Group's (TNET) CEO Burton M. Goldfield on Q3 2017 Results - Earnings Call Transcript

TriNet Group, Inc. (NYSE:TNET) Q3 2017 Earnings Conference Call November 2, 2017 5:00 PM ET

Executives

Alex Bauer – Executive Director, Investor Relations

Burton M. Goldfield – President and Chief Executive Officer

Richard Beckert – Chief Financial Officer

Analysts

Tien-tsin Huang – JPMorgan

David Grossman – Stifel

Timothy McHugh – William Blair

Danyal Hussain – Morgan Stanley

Operator

Good afternoon, and welcome to the TriNet Group, Inc. Third Quarter Earnings Conference Call. All participants will be in listen-only mode. [Operator Instructions] After today’s presentation, there will be an opportunity to ask questions. [Operator Instructions] Please note this event is being recorded.

I would now like to turn the conference over to Alex Bauer, Executive Director, Investor Relations. Please go ahead.

Alex Bauer

Thank you, operator. Good afternoon, everyone, and welcome to TriNet’s 2017 third quarter conference call. Joining me today are Burton M. Goldfield, our President and CEO; and Richard Beckert, our Chief Financial Officer. Our prepared remarks were prerecorded. Burton will begin with an overview of our third quarter operating and financial performance. Richard will then review our financial results in more detail. We will then open up the call for the Q&A session.

Before we begin, please note that today’s discussion will include our 2017 fourth quarter guidance and other statements that are not historical in nature, are predictive in nature or depend upon or refer to future events or conditions such as our expectations, estimates, predictions, strategy or other statements that might be considered forward-looking. These forward-looking statements are inherently subject to risks, uncertainties and assumptions that may cause actual results to differ materially from statements being made today or in the future.

Except as may be required by law, we do not undertake to update any of these statements in light of new information, future events or otherwise. We encourage you to review our most recent public filings with the SEC for a more detailed discussion of these risks and uncertainties that may affect our future results or the market price of our stock.

In addition, our discussion today will include non-GAAP financial measures, including our forward outlook for non-GAAP Net Service Revenues, adjusted EBITDA and adjusted net income. For reconciliations of our non-GAAP financial measures to our GAAP financial results, please see the company’s earnings release available on our website or through the SEC website. A reconciliation of our non-GAAP forward outlook to the most directly comparable GAAP measures is available on our website.

With that, I will turn the call over to Burton, for his opening remarks.

Burton M. Goldfield

Thank you, Alex. I am pleased with our third quarter performance. In the third quarter, we grew GAAP revenue 6% year-over-year to $819 million and we grew our Net Service revenue by 28% year-over-year to $206 million. Professional service revenue increased 2% year-over-year to $113 million. Professional service revenue benefited in the quarter from a mix shift in our business and higher service fees per employee per month due to the pricing of our vertical products.

Net Insurance Service Revenue for the quarter increased 85% year-over-year to $93 million. Net Insurance Service Revenue again outperformed our forecast in the quarter due to three factors. First, Net Insurance Service Revenue improved in the quarter due to an increase in the number of worksite employees participating in our plans. Our worksite employees continued to enroll in our plans as they found our offerings more attractive than other choices in the market.

Second, Net Insurance Service Revenue benefited from better-than-expected claims experience in both health and workers’ compensation. In the first half, our total insurance cost came in 2% lower than planned. We had forecasted that our cost in the third quarter would revert to our historical trend. Instead, claims experience continued to come in lower than expected. And finally, Net Insurance Service Revenue benefited from additional administrative cost savings. I will provide more color on our administrative cost-savings later in the call when I review our operational performance.

Our third quarter GAAP EPS grew 200% year-over-year to $0.60 per share, and our Q3 adjusted net income per share exceeded the top end of our guidance by $0.29 at $0.56 per share. Overall, I am pleased with our financial performance, especially given the effort and focus on our ambitious operating objectives in FY 2017.

We delivered a more intuitive user interface, enabling improved productivity for both online and mobile users. We introduced our API-first strategy, allowing our platform to integrate more efficiently with third-party products. We view this functionality as a critical component of our client’s overall ecosystem as they succeed, grow larger and grow more complex.

We launched TriNet Main Street during the third quarter targeting industries including hospitality, property management and retail. TriNet Main Street is our fifth vertical product and joins our growing vertical product portfolio, which includes TriNet Technology, TriNet Financial Services, TriNet Life Sciences and TriNet Nonprofit.

The TriNet Main Street product addresses the needs of a large segment of the small and medium business market with an improved product that offers intuitive payroll, robust time and attendance, comprehensive workers’ compensation offerings, cost-effective employee benefits and expert compliance support, along with a competitive price point.

Since launching TriNet Main Street in July, we have continued to expand the product’s functionality and expect to add additional features in the next six months. TriNet Main Street’s expanding functionality both enables us to sell into a broader cohort of prospects and allows us to better map the migration waves of our legacy SOI clients, the majority of which will be migrated to TriNet Main Street.

The central goal of our product and technology upgrade is to provide our clients with the best possible experience. We expect a majority of the migration to be completed by year-end, with the remainder occurring in the first quarter of 2018. In doing so, we have better aligned those clients with their benefits renewals and with TriNet Main Street’s release functionality.

Finally, let me return to the topic of our administrative cost-savings associated with our insurance offerings. Leveraging our scale for the benefit of our clients is a key component of our business model. We believe that several of our initiatives are beginning to demonstrate the potential of increased scale. Over the last several months, TriNet generated significant administrative cost-savings in managing our health insurance relationships. Our insurance services team leveraged TriNet’s scale to successfully drive down certain fixed cost associated with our insurance programs.

For example, effective in the fourth quarter, we are changing our economic arrangement with one of our major carriers to more closely align with certain arrangements of our other major carrier partners. Because of changes like this, we expect additional cost-savings in Q4 as well as in 2018. Longer term, we will look for additional opportunities that we believe will provide a more competitive price point and/or additional services for our clients.

Another benefit from our realized cost-savings within our insurance programs is that we provided a 2017 fee credit to certain clients. By way of background, a significant component in the pricing of insurance by our carriers depends on national or industry trends. However, we’re trying to realize administrative cost-savings, we create value that can accrue to our clients in the form of improved plan benefits or reduced fees.

Given my confidence in our team’s ability to maintain the recently achieved administrative savings, we have provided qualified clients a fee credit. These clients are experiencing the tangible benefits of TriNet’s growing scale. Whether derived from our financial strength or through our investment in technology, TriNet is committed to leveraging its scale for the benefit of our clients while maximizing profitable growth for the benefit of our shareholders.

With that, I will pass the call over to Richard for his review of our financial performance. Richard?

Richard Beckert

Thank you, Burton. As we review the financials, I will focus on the GAAP numbers and discuss the non-GAAP numbers where appropriate. During the third quarter, GAAP revenue increased 6% year-over-year to $819 million. Net Services Revenue increased 28% year-over-year to $206 million. We finished the third quarter with over 325,000 worksite employees, down 3% year-over-year. Average WSE count for the third quarter was over 324,000, down 2% year-over-year. In the third quarter, our average WSE count was again impacted by the increased attrition, including attrition attributable to our SOI migration. We expect the trend to continue over the next couple of quarters as SOI migration is completed.

Professional services revenue for the third quarter increased 2% year-over-year to $113 million. When compared to the same quarter last year, professional service revenue benefited from improved pricing and slight mix shift away from the blue and gray vertical. Professional service revenue growth was negatively impacted by our lower average WSEs.

Net Insurance Service Revenue for the third quarter increased 85% year-over-year to $93 million. Net Insurance Service Revenue benefited from positive realized health experience, which came in below our guided incremental 2% insurance cost growth, and contributed $0.14 above the top end of guidance. Increased enrollment beyond our forecast and workers’ compensation which performed better than forecast contributed $0.04 due to the increased pricing to risk.

Total adjusted EBITDA for the third quarter increased 77% year-over-year to $80 million compared to $45 million during the prior period. GAAP net income increased 194% year-over-year to $43 million or $0.60 per share compared to $15 million or $0.20 per share in the same quarter last year. Adjusted net income increased 94% year-over-year to $40 million or $0.56 per share compared to $21 million or $0.29 per share in the same quarter last year.

Our GAAP effective tax rate was 26.3% for the third quarter and our Q3 pro forma tax rate was 40.5%. The decrease in the Q3 GAAP effective tax rate was primarily driven by the income tax accounting treatment for employee-based equity compensation.

During the third quarter, we generated $55 million in operating cash flow versus $37 million in the same quarter last year and spent $8 million in CapEx, representing 4% of the Net Service Revenue and net cash generation of $47 million.

In the quarter, our operating cash flow benefited from increased net income and change in cash taxes. We closed the quarter with total debt of $432 million, representing debt-to-EBITDA ratio of 1.6x trailing 12-month EBITDA. We spent nearly $10 million to repurchase approximately 284,000 shares of stock during the third quarter. We finished the quarter with total cash of $264 million and working capital of $187 million.

As Burton discussed, we recently provided certain clients with a 2017 fee credit. Over the last year, TriNet has benefited from our scale as we drove down administrative cost associated with our insurance offering. Through our 2017 fee credit, we are bringing forward some of the benefits of scale to clients by providing credits to the segment of our installed base. The 2017 fee credit amount will be based on our 2017 results and credited to clients during the first quarter of 2018. The credit will be treated as sales revenue credit during the fourth quarter and is included in our revised fourth quarter guidance.

Turning to our fourth quarter outlook. I will provide both GAAP and non-GAAP guidance. In an effort to provide greater transparency in our business model, we have decided to widen our quarterly Net Service Revenue range to $35 million to reflect the 2% up or down movement in insurance costs. Our forecast also includes the beneficial impact from the new economic arrangement with one of our health plans.

For the fourth quarter, we forecast GAAP revenue in the range of $825 million to $840 million, which represents year-over-year growth of 2% to 4%, and Net Service Revenue in the range of $185 million to $220 million, which represents year-over-year growth of 7% to 27%. We expect the fourth quarter adjusted EBITDA in the range of $47 million to $82 million, representing an adjusted EBITDA margin of 25% to 37%. Our fourth quarter GAAP net income is expected to be in the range of $19 million to $44 million or $0.26 to $0.63 per share, and we expect fourth quarter adjusted net income in the range of $20 million to $41 million or $0.28 to $0.58 per share.

Turning to our full year guidance. Given the three quarters of performance and our fourth quarter guidance, we now forecast GAAP revenue in the range of $3.25 billion to $3.27 billion, representing year-over-year growth of approximately 6% to 7%. We forecast Net Service Revenue of $791 million to $826 million, which represents year-over-year growth of 22% to 28%.

For FY 2017, we expect adjusted EBITDA in the range of $263 million to $298 million, representing an EBITDA margin of approximately 33% to 36% and year-over-year growth of 41% to 59%. Our GAAP net income is expected to be in the range of $131 million to $156 million or $1.84 to $2.20 per share. And we expect our FY 2017 adjusted net income in the range of $129 million to $150 million or $1.82 to $2.11 per share. As is our practice, we will provide guidance for 2018 when we report our fourth quarter and full year 2017 results.

This concludes the third quarter financial results overview. I will now pass the call back to Burton for his closing remarks.

Burton M. Goldfield

Thank you, Richard. Before concluding this call, I would like to take a minute to formally welcome Barrett Boston, who, as previously announced, has joined TriNet as Senior Vice President and our Chief Revenue Officer. This newly created position will be responsible for both acquiring new clients as well as managing the revenue growth and long-term business relationships with our installed base clients.

Barrett most recently served as Executive Vice President with TravelClick, Inc., a global leader in cloud software solutions for the hospitality industry, where he was responsible for the acquisition and retention of customers. Barrett has over 20 years of broad leadership experience from sales strategy to execution, including 12 years with IBM. Barrett’s blend of SMB and enterprise expertise, coupled with verticalized solution-based sales skills, makes him a strong addition to TriNet and our executive team. Welcome, Barrett.

Again, I am very pleased with our teams’ performance in the third quarter. Our business model is centered on leveraging our scale for the benefit of our clients while maximizing our ability to deliver profitable growth for our shareholders. We are making good progress on these fronts and they are showing in our results. We now need to continue to execute against our strategy to drive growth and profitability going forward.

And with that, let me turn the call over to the operator for the Q&A session.

Question-and-Answer Session

Operator

[Operator Instructions] Our first question comes from Tien-tsin Huang with JPMorgan.

Tien-tsin Huang

I wanted to ask on the fee credit. Is the idea there to get higher retention results or maybe higher participation? What’s sort of the – what do you expect to get in return for that? And maybe just a bigger picture question on pricing. Just given your claims experience and the admin cost-savings, so far, does it change your insurance pricing philosophy in the short term and the long term?

Burton M. Goldfield

Tien-tsin, this is Burton. Thanks so much for the question. To me, this is about partnering with our clients. And as I’ve talked about, we are building scale in service of those clients. The three ways I can show those clients increase value from my vantage point is: first, technology enhancements; second is service enhancements and additional functionality; and third is the pricing. So what I wanted to do was share with existing clients the benefit of the scale.

We’ve talked about for a few quarters that the work that’s been done in leveraging the administrative cost of insurance has gone down, and it was trying to show folks that by partnering with TriNet, the long-term future is for each of those three areas to be enhanced, both the technology, the service and functionality as well as the pricing. So, so far, the outreach has been well received and we believe it’s commensurate with this idea of building scale in service of the entire client base.

Richard Beckert

And if I can just add one thing, yet again in Q3, we saw our growth rate of 4%. So we don’t see that as an insurance cost or price issue.

Burton M. Goldfield

Right. So as opposed to giving a discount on insurance, this was a very different feel for me.

Tien-tsin Huang

Got it. That makes sense. It’s smart. It’s interesting. I mean, like I said, sharing the economies of scale. It kind of answers the philosophy question. Just my quick follow-up, just trying to understand the professional services revenue, up 2%. WSE count is down 2%, 3%. So that spread, I guess, is a result of the vertical pricing, which you talked about. Is this just a beginning of that? Could we see that spread widen even between WSE count and professional services revenue?

Richard Beckert

Remember, as Burton has said in his prepared remarks, as SOI goes down, the dollar per PEPM is a little bit lighter than the other verticals. That being said, we are seeing good growth in the other verticals. So it’s just a mix change and the philosophy of having sales reps going by vertical, we are seeing the benefit of that in price.

Burton M. Goldfield

So mix shift, Tien-tsin, as well as increased pricing account for that change. But having said that, and I’m sure you realize it, these are pretty exciting times. What was announced directionally this morning on the tax proposal, it is phenomenal for our clients and will impact TriNet. So I’m pretty excited, particularly the R&D credit in the verticals like Life Sciences and Technology, and there’s a whole bunch of other things in there. And obviously, we have to wait in this political climate to see how it plays out. But from my vantage point, the idea of a focus on these core verticals that we’re excited about, giving them more value, partnering with them will help us in years to come.

Operator

Our next question is from David Grossman with Stifel.

David Grossman

There’s obviously a lot of moving pieces here. And I’m wondering if I could just hit a couple of them. I guess the first one is on the trends in WSE growth. Obviously, we’re experiencing the impact of the SOI migration to the new platform and repricing of the workers’ comp book. So is this a good indication of what to expect in the next two quarters? Is that complete? Or is there a bell curve to this that I’m not fully appreciating?

Burton M. Goldfield

So David, as we’ve discussed on numerous occasions, this was always to be a transition year. My goal is to have a transition year with top line revenue growth and margin expansion, and I believe we will achieve that. What I want to assure you is that annualized revenue and earnings growth this year and next year and into the future. Having said that, everything that we are doing is to foster volume growth in the future. You mentioned the moving parts. We are migrating SOI onto the Main Street platform. We are repositioning our risk book.

We are actively working on enhancements to our products and services. We are implementing the vertical strategy. We’ve hired an exceptional new leader for our sales organization. So as those different elements shake out, and as you point out at different times, I expect a return to WSE growth and also increases in profitability and top line revenue.

David Grossman

Right. So just speaking a little bit more specifically about timing then, Burton, it sounds like you’re trying to get the SOI book migrated by the end of the March quarter. So is it fair to say that those headwinds start to abate pretty significantly on a sequential basis after the March quarter?

Burton M. Goldfield

So what I would say is I am very excited about the focus after the March quarter once we complete that migration to the single platform.

David Grossman

Okay, fair enough, fair. And then just getting to the fee credit, just so I understand the mechanics of this, so are we going to accrue for that? And is that accrual reflected in your 4Q guidance, it just gets paid out in 1Q? Or is that an accrual that gets made next year based on 2017 experience?

Richard Beckert

No. We have that impact that’s already recorded in the guidance we gave you for Q4. And then the cash credit portion of that will happen in Q1 of next year, but the revenue impact is recorded in Q4.

Operator

Our next question is from Timothy McHugh with William Blair.

Timothy McHugh

I read this fast because it just came out. But I guess the Q said that the change in the kind of insurance arrangement is going from a full guarantee to kind of an at-risk model. Can you talk about that dynamic, I guess, and how much of the business, I guess, or kind of client base are we making this change as it relates to...

Richard Beckert

Sure. So we’re changing it to have this line up with the rest of our business, right? So you now have guaranteed cost with a minimum premium plan. In Q4, we said it’s $0.13. It will give us additional benefit in 2018. It does add a little volatility, about $3 million or $0.03 in any quarter. And we already have all of that factored in, and that’s a little bit why we widened guidance. So that’s all been reflected in there.

Timothy McHugh

Okay. How much of the client – I mean, is this particular kind of vertical market? I mean, can you remind me, I guess...

Richard Beckert

We’ll let you know more as the year goes on. We’ll update you. It’s about 10,000.

Timothy McHugh

Okay. 10,000 WSEs in that, I’m assuming?

Richard Beckert

Correct. That’s why – so we will give you a more precise number at the end of Q4.

Timothy McHugh

And is there any way you can quantify the kind of fee credits to the clients? And I guess...

Richard Beckert

We’re not going to give that out as of right now. Yes, we have quantified it already internally, and we have that factored in. What we would say, we went through – as Burton said, it allowed us to go out and touch a large number of our customers in a very positive way. It was viewed as a very positive experience and it really does allow us to demonstrate how, with our admin fee improvement, we can help share with that as a partnership. It’s been very well received by the market.

Timothy McHugh

Okay. And then lastly, the functions around insurance in the last quarter, you assumed that after seeing first half kind of below plan, you would revert back to plan. I guess, for Q4 here, have we changed the view of kind of on trend? Or are you still reverting – assuming a reversion back to where you were earlier this year?

Richard Beckert

Yes. To be clear, last quarter, what we have said is we thought we would actually go above the trend. This quarter and the fourth quarter, we’re saying we will be on trend.

Operator

[Operator Instructions] Our next question comes from Danyal Hussain with Morgan Stanley.

Danyal Hussain

I think you previously mentioned an expectation that you’d share the lower admin cost with your clients, I think, in its entirety. So is this fee credit, is that the revenue share? And it sounds like now you’re keeping – or at least the way it sounds, you’re keeping some of the economic and sharing just a portion of it. Is that right?

Richard Beckert

Yes. This is Rich. I don’t believe we ever said we would flow the entire amount back. I do think we are demonstrating to our customers that we are sharing in some of that. More importantly, what that admin fee allows us to do though is give a very competitive overall price package back to our customer set and it makes us more competitive. And as we get larger, we believe we’ll be able to continue to exert that kind of flexibility, which is a real benefit for our customer base.

Danyal Hussain

Okay. So considering now this fee credit plan and the fourth quarter renegotiation with the one carrier, could you give us a revised outlook for insurance cost as a percent of gross insurance revenue, what a normal year would look like?

Richard Beckert

We still think we’re in that range of 8% to 10% range. Just so you know Q3 came in at 13%.

Danyal Hussain

Okay, all right. And then a question on the migration, could you quantify how much of it is completed at this point and whether you think you’ve already troughed in terms of the demand of attrition you’ve seen or whether you think that can pick up in the fourth quarter?

Burton M. Goldfield

Danyal, this is Burton. We expect to migrate over half the installed base by year-end, and as I said, the balance in Q1. We’re on the third round of migrations. In fact, we started today on migrating over 10,000 WSEs that will take place over this weekend. And I expect it to complete by Sunday. And I’m happy with the migration and particularly happy that these waves are being aligned with both the functionality and now with the renewals of the insurance for our customer base. So bottom line is I’m pleased with the number that had been on-boarded. And equally as important is I’m happy with the pipeline for new business on our brand-new Main Street product.

Danyal Hussain

Okay, great. And then, Burton, just a question on getting back to that WSE growth. You’d probably need – at least I think you need to accelerate sales rep growth again. Could you just give an overview of how you expect that to play out, whether the hiring take place this year or maybe later into next year? And then could you give an update for the sales rep count in the third quarter?

Burton M. Goldfield

So great question. I did not feel a strong need to accelerate sales rep growth because there’s dramatic increase in productivity between what we call level 0 and level 1 after they complete one year. The retention of the reps is up dramatically year-over-year, and my feeling is as these reps get more adept and focused in their verticals, there will be a natural uplift in productivity, which will help me significantly in 2018. I’m also very excited about Barrett joining to lead the sales effort. And he’s already having an impact even a week on the job.

So from my standpoint, I believe we will be able to meet our vision for 2018 without significant sales rep growth based on the maturity of our reps. And I look for Barrett and Rich to give me the final plan and us to move forward. But both the maturation of the products, the focus away from this migration once it’s complete and the maturity of the Main Street product with additional functionality are all things that get me pretty optimistic. From a micro view and then a macro view, I just believe that the opportunity for our industry and for TriNet particularly is very, very good with the stimulation that I believe small businesses will achieve with any tax changes as well as the overall economy.

Operator

This concludes our question-and-answer session as well as today’s conference. We thank you for attending the presentation and you may now disconnect your lines.