My investment thesis on Insperity (NYSE:NSP) is not based on the short-term challenges being faced by the company, but rather on its long-term growth potential. But these short-term challenges have proven to be, without doubt, pain points for the company. From its high of $144.92 in July 2019, the share price has declined 50%.
Insperity's Transformation
Insperity is now an HR solutions provider. Initially, it operated as a professional employer organization (PEO), a model still foreign to many. In a PEO model, the employee is “co-employed” by an administrative employer, such as Insperity, and the worksite employer. Under its PEO umbrella, the company offers human resource and business solutions, including recruiting, training, employee management, payroll, benefits administration, workman's compensation administration and retirement benefits management.
To fuel its track record of double-digit growth, in early 2017, Insperity opted to expand its offerings for companies not interested in or not ready for a PEO model. It began development of a traditional HR service. By the 2018 second quarter, the offering had been branded Workforce Acceleration. Acceleration is defined as a “self-service, human capital management software bundle, plus professional HR support as needed”.
Additionally, in 2018, Insperity developed a focused offering for a mid-market demographic. The company honed in on companies with 150 to 5,000 employees needing customized solutions.
For each of its solution, Insperity focuses on selling to healthy and thriving companies. Its pitch encourages businesses focus on their core business and outsource the extraneous HR responsibilities. Insperity offloads the requirement to be well-versed and competent regarding employment laws, tax regulations, and government compliance. Especially for a small to medium-sized business, the idea of being able to focus on the core business while relying on a competent partner to handle administrative duties, is appealing. Plus, because of economies of scale, Insperity is able to offer more attractive benefits options than individual companies.
2019 Full-Year Results
On February 11, 2020, Insperity reported fourth-quarter and full-year results. Yet again, the company generated double-digit growth. For the quarter, revenue improved 11.2%, from $966.8 million in the 2018 fourth quarter to $1.08 billion in the same quarter of 2019. For the year, revenue climbed 12.7%, from $3.83 billion in 2018 to $4.3 billion in 2019.
Gross margin declined 80 basis points to 17% for the year. As a result, the increase in gross profit for the year was only 7.5%, from $681.9 million in 2018 to $732.9 million in 2019.
Additional headcount and the opening of nine new sales offices drove an 8.6% increase in operating expenses. This resulted in an operating income improvement of only 4.2%, from $179 million in 2018 to $186.6 million in 2019.
An 18% smaller tax expense drove an 11.6% improvement in net income, from $135.4 million in 2018 to $151.1 million in 2019. As well, Insperity lowered its outstanding share count by repurchasing 2.1 million shares in 2019 at a cost of $203 million. Adjusted diluted earnings per share rose 10.7%, from $3.75 in 2018 to $4.15 in 2019.
The company points beyond the top and bottom line to truly measure growth.
But as you all know, it isn't about our revenue anyway. It's about the gross profit and the contribution at the operating income line because every worksite employee is a unit of revenue and unit of risk.
At this level, for the full year, gross profit declined 4.8%, from $272 per WSEE in 2018 to $259 per WSEE in 2019. Operating income declined 7%, from $71 per WSEE in 2018 to $66 per WSEE in 2019.
Despite the double-digit increases on its top and bottom line, the company faced significant challenge in 2019.
In the last three quarters, Insperity experienced an unusual number of occurrences of large medical claims (defined as $250,000 and above). The total cost was approximately $37 million. Yet, its insurance carrier determined through multiple reviews the activity was indeed random.
During Q4, the number of large claims continue to decline from the high point in Q2, however remained elevated when compared to the periods prior to Q2 of 2019. And, we, once again, performed an in-depth analysis of the large claim activity. Similar to Q3, a detailed review of the Q4 claims continued to indicate that the large claims were associated with a very small number of participants. The claims were largely from different participants as opposed to ongoing claims from the same group of participants in prior periods. And, a review of the clients associated with these large claims did not indicate a concentration associated with new clients, COBRA participants or a particular region.
Insperity determined, had it not been for the extra costs from the large claims, it would have met its projection for adjusted EBITDA. Initially, the company projected adjusted EBITDA in a range of $268-285 million. After reporting first-quarter results, it bumped the adjusted EBITDA range to a range of $276-289 million. Including the extra costs, adjusted EBITDA totaled $250 million on the year.
Another challenge was rooted in the growth of WSEEs, as it did not pace as initially projected for the year. At year end 2018, Insperity projected the average number of paid worksite employees would grow in 2019 to a range of 238,400-242,600. With third-quarter reporting, the company lowered its full-year expectation to a range of 235,700-236,300. The average number paid in 2019 was 235,547, barely missing the updated low end and 1.2% less than the initial low end of the range. It is pertinent to recognize the growth still represented year-over-year growth of 12.6%, well within Insperity's long-term target of 10-15% annually.
A combination of factors impacted the expectation. First, Insperity noted there simply were not qualified applicants to hire. This same factor impacted the company's ability to hire its own BPAs (Business Performance Advisors).
It’s taking a lot more interviews and a lot more activity to bring the same number on.
Yet, by the end of 2019, it had added 12% more trained BPAs.
Also, despite tracking on volume, Insperity was unable to close as large an account in its mid-market business in 2019 as it did in 2018.
We sold the same number of accounts in mid-market last year as we did the year before, but the average size was smaller.
Finally, its client attrition rose to 7.3%, 180 basis points above the 2018 mark. After analyzing the factors, Insperity determined mergers and acquisitions in its emerging growth and mid-market segments were the culprit for nearly half the difference. The next major factor related to cost or value. Approximately 60% of this group resumed operations in-house, while approximately 40% moved to competitors.
Insperity reported its fall sales campaign was on track relative to goal through October. But November sales dropped off. Though the company extended the campaign through January, the timing meant sales were not closed until the 2020 first quarter. Ultimately, sales did recover, and even exceeded the campaign goals. The push should also benefit 2020 activity.
Remarkably, we also boosted future sales activity with a 28% increase in discovery calls and a 40% increase in business profiles.
2020 Guidance And Pain Points
Insperity began 2020 with a lower-than-expected starting point in paid worksite employees. Adjusted EBITDA is projected in a range of $250-274 million, compared to $250 million in 2019. Net income is projected in a range of $128-145 million, compared to $151.1 million in 2019. Adjusted diluted earnings per share are projected in a range of $3.73-4.16, compared to $4.15 per share in 2019.
To address the risk of large medical claims, Insperity opted to add a new feature to its health plan. The company will no longer be responsible for reimbursing its insurance carrier on claim costs above $1 million in a calendar year on an individual participant. This will, at least, cap its exposure on large claims.
M&A activity in its emerging growth and mid-market segments is not a factor the company can necessarily eliminate. And even though Insperity found the remaining attrition occurred in its “price-sensitive” or lower-priced clients, it intends to continue to focus on how to improve the retention rate by addressing the cost and value attrition factors.
Insperity's goal for trained BPA growth in 2020 at 11% is lower than its 2019 growth of 12%. But the company's progress on data science and analytics should improve its sales efficiency.
Potential
Insperity operates only 81 sales offices in the United States. It supports over 100,000 businesses employing over 2 million employees.
The company estimates there are approximately 71 million employees employed in 7 million businesses with less than 5,000 employees. This would imply over 97% are available for pursuit. But it targets only healthy and thriving businesses.
Using 20,000 specific and custom data points, Insperity's data science and analytics effort confirmed its total addressable market opportunity.
Now out of the seven million small and midsized businesses in the United States, this analysis shows that there are over 1.7 million companies at a 50% fit. We can now confirm that this analysis shows more than 600,000 prospects with a 75% fit, lining up with our previous estimate. More importantly, we can actually identify these companies market-by-market that fit this precise demographic and psychographic profile.
Now this is where it gets interesting. Analyzing the pattern of behavior of our clients before they became customers has provided information to determine intent - looking for the services we provide and engagement - actually interacting with us or competitors. These activities or patterns of behavior can also be compared to the universe of prospects at any given time. For example, when we ran this analysis early this year, at a 90% fit, there were over 190 perfect fit prospects, with just under 16,000 showing intent at that time.
Takeaway
No doubt, 2019 was a tough year for Insperity (and its shareholders), especially when compared to the previous four years. But growth does not come without a hitch here or there. The last year proved the company still has things to learn and room to improve, especially as it expands into the mid-market demographic.
But 2019 also proved Insperity's model and processes do work. Adding the data science and analytics results to this should improve efficiency and prove fruitful. Thus, although the company is not expecting 2020 to show significant growth on the bottom line, 2020 should provide proof of the effectiveness of its focus.
My investment club is a current shareholder, and we have long ago recouped our original investment. There's no need for us to give up on Insperity just as it establishes its footing before its next growth spurt.
