Today we shared our research and opinion on Barrett Business Services (NASDAQ:BBSI). Highlights of our opinion/report are below, with our full opinion found here: www.scribd.com/doc/239934271/Barrett-Bus...
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We believe Barrett Business Services (BBSI) operates with a precarious business model and substantial reserve deficiencies, which has created immense blow-up risk for public market investors. The combination of aggressive growth into the pernicious California workers' compensation market and minimal transparency regarding a recently disclosed reserve study has created an un-investable stock. Our work suggests BBSI has systematically under reserved, which has resulted in materially overstated earnings and a high probability of a massive reserve charge. With only three covering sell-side analysts (none of whom appear to have any insurance domain expertise based on a collective coverage universe that includes movie theatres, executive staffing, water dispensers, and ecommerce solutions), the combustible issues at BBSI have largely escaped investor scrutiny. That should change with our report, which includes a compendium of forensic issues, as well as background on BBSI's model and end markets.
Based on our analysis of 2013 incremental adverse development (applied to 2012 claims expense), we believe BBSI may have overstated earnings by 57%. Depending on the degree to which BBSI's reserves may be inadequate, there are scenarios discussed herein which would completely wipe out BBSI's previously reported profits. In addition to arguing our belief that BBSI has overstated past earnings, we outline why BBSI appears to be in blatant violation of U.S. GAAP accounting. Our accounting concerns are amplified by a 2014 lawsuit brought by a long tenured branch manager accusing BBSI C-Suite executives of "effectively cooking the books to create inflated profit margins to entice interest in BBSI stock in violation of SEC regulations."[i] Unsurprisingly, we have been unable to find any disclosures in BBSI's public filings about the existence of the lawsuit and associated incendiary charges. BBSI's auditor is tiny Moss Adams, who does not even list insurance as an area of expertise on its website.
It is well understood that insurance companies can hide long-term economic liabilities for extended periods of time. However, a recently announced reserve study should act as the catalyst to publicly expose the magnitude of BBSI's reserve hole. The dramatic shift in IBNR and case reserves are additional red flags, with the latter inexplicably increasing from $51 million to nearly $93 million in BBSI's most recent quarter. Based on our analysis, if BBSI simply matched the reserve coverage of other PEOs and insurance companies, a charge between $69 million to $280 million would be required. For perspective, BBSI's shareholder equity at 6/30/14 was just $74 million. A reserve charge representing just a fraction of our estimate would likely eliminate years of pretax earnings, while creating uncertainty over BBSI's profitability and ongoing business model.
Adding even more asymmetry to BBSI's stock is the new fronting agreement with ACE. Should the reserve study (or other issues discussed herein) cause ACE to non-renew its fronting agreement, BBSI's corporate profile could be impaired with no replacement to renew its California business.
Under a rosy scenario analysis that assumes BBSI is somehow able to delay reserve charges, we still believe the stock will revalue significantly lower to account for balance sheet risk and incremental earnings pressure from regulatory changes occurring on January 1, 2015. Generously assuming benign outcomes for many of the issues identified in this report, we still believe fair value for BBSI's stock is $29.00 per share, which is 50% below its recent price. The $29.00 per share scenario assumes the company is NOT required to take significant reserve charges to address its thin reserve position, has no negative changes in its ACE fronting agreement, and no restatement of past results for inappropriate reserving practices occur. On the other hand, if we are correct about the considerable hole in BBSI's reserve, we believe there are a plethora of long-tail scenarios that could cause the stock price to go much, much lower. We encourage all shareholders (and sell-side promoters) without insurance expertise to consult an insurance expert to independently verify our analysis and conclusions.
Our report contains several sections focused on relevant background information on BBSI, workers' comp, as well as the California PEO dynamics. Other sections are specific to the problems we have identified at BBSI, including detailed analysis examining BBSI's reserving practices and business/financial models. For those with time constraints, we would encourage you to jump directly to sections 4, 6, 7, and 8, which provide the most specific analysis and discussion into the significant risks and "meat" of our BBSI opinion. If you can only read one section in its entirety, please see section 6 ("Severely Inadequate Reserves May Require a Significant Charge"). Sections 1-3 provide relevant, yet admittedly boring background. The following segments are covered in this report:
1) Investors Should View BBSI as an Insurance Company - BBSI is a PEO with a small staffing business. The PEO represents approximately 95% of gross revenues. BBSI competes in the challenging market of providing workers' compensation insurance for blue collar employers. Further, most of its exposure growth has come in California, which now represents roughly 74% of net revenues. Over the past three years, the new management team more than doubled the company's exposure to this risky market.
2) A Brief Background on the Seedy History of PEOs - The PEO industry has a tumultuous history that is marred by extensive fraud. In recent months, officials tied to several PEOs were sentenced in one of the largest insurance fraud cases ever, misappropriating $133 million of their clients' money. According to the FBI, "Workers' compensation insurance accounts for as much as 46 percent of small business owners' general operating expenses. Due to this, small business owners have an incentive to shop workers' compensation insurance on a regular basis. This has made it ripe for entities that purport to provide workers' compensation insurance to enter the marketplace, offer reduced premium rates, and misappropriate funds without providing insurance."[ii]
3) California Bans PEOs - Under Senate Bill 863, all California PEO licenses, including BBSI's, will be revoked on 1/1/15. This provision passed due to concerns related to the financial stability and/or solvency of the industry following PEO bankruptcies in the State. BBSI's core PEO business will effectively be banned on 1/1/15, likely resulting in a significant growth and/or earnings hit.
4) BBSI Losing Its License = Possible Collapse of Growth and/or Earnings - In response to getting its license revoked, BBSI entered a fronting agreement with ACE, a rated and admitted insurance company. We believe management has misled investors on the financial impact of this fronting agreement. After initially describing it as "earnings neutral," management recently revised the estimated potential drag to 25 to 30 basis points. A 25 to 30 basis point hit relative to gross revenue would have cut 2013 earnings by as much as one-third. BBSI's second quarter 10Q suggests the fronting costs may already be 2x management's updated estimate, with approximately 66% of its clients still not transitioned to the more expensive policy forms. We expect significant earnings pressure as the remaining two-thirds of clients transition to the ACE fronting arrangement.
5) A "Reserve Study" By Any Other Name Would Smell as Rancid - On July 30, 2014 BBSI's management disclosed that a third party actuary had been hired to conduct a reserve study of its insurance reserves. Two similar reserve study announcements (GNW and TWGP), both with similar workers' compensation exposure, resulted in significant stock price declines. It is unclear why BBSI is conducting a reserve study now, but we believe ACE, BBSI's new fronting partner, may be the driver. While management has provided minimal transparency or detail into the reserve study, based on our reserve analysis, we believe it is reasonable to assume ACE may not be comfortable with BBSI's existing reserve. Our suspicion is that one of ACE's preferred actuaries (Milliman or Willis) is conducting the study. If the third party actuary results are not addressed appropriately, it is possible ACE will not renew their fronting agreement with BBSI. A non-renewal could shut-down BBSI in California post SB 863.
6) Severely Inadequate Reserves May Require a Significant Charge - We believe the ongoing reserve study will reveal a large hole in BBSI's reserve position. Our in-depth review suggests BBSI may be required to recognize a material charge to substantially increase its loss reserves. We analyzed five significant red flags at BBSI: 1) persistent prior year reserve development, 2) exposure, revenue, and claims payment growth well in excess of reserve growth, 3) irreconcilably low short-term reserves, 4) extremely thin IBNR levels, and 5) reserve levels well below paid claims. Each of these red flags suggests BBSI has severely inadequate reserves. Further, our analysis suggests BBSI met their earnings guidance in the second quarter 2014 by dramatically under accruing claim expenses. Based on BBSI's low level of short-term reserves, and the decline of short-term reserves as a percentage of overall reserves, we believe BBSI will need to take a charge of at least $30 million. Our analysis concludes a charge of this magnitude would be required to simply increase short-term reserves to a level that would cover claim payments over the next twelve months. Additionally, BBSI's SEC filings illuminate a dramatic shift in IBNR and case reserves, with the latter inexplicably increasing from $51 million to nearly $93 million in the most recent quarter. Generally, IBNR makes up a substantial portion of long-tail insurance reserves. However, IBNR constitutes just 24% of BBSI's reserves. BBSI will need to take a charge of approximately $63 million to move its IBNR inline with a comparable group of workers' compensation insurers. We show how BBSI's run-rate of paid claims would deplete their reserves significantly faster than the comp group, despite BBSI's rapid exposure growth (and the backward looking nature of paid claims versus the supposedly forward looking nature of reserves). According to our analysis, matching the reserve coverage of other PEOs and insurance companies would require BBSI to recognize a charge between $69 million and $280 million.
7) BBSI's Reserving Practices & Accounting Appear to Violate GAAP Resulting in Overstated Earnings
Management's public description of its reserving practices appears to violate U.S. GAAP accounting, specifically FAS 60. Management recently explained its accounting approach, which indeed matches BBSI's historical financials. Neither their explanation, nor the historical financials appear to conform to U.S. GAAP. We clearly analyze how reserve accruals related to prior accident years constitute an inexplicably large percentage of the total reserve accrual. The consistently high accrual for prior years is inconsistent with other PEOs and insurance companies. As a result of its unorthodox accounting, we believe BBSI has dramatically overstated past earnings. Applying the incremental adverse development in 2013 to claims expense the prior year, suggests that 2012 EPS was overstated by 57%. We believe an accounting restatement may be required, which would result in substantially lower historical earnings. BBSI's auditor is Moss Adams, who does not appear to audit other insurance companies, or even list insurance as a practice area.
8) Insurance Subsidiary Inconsistencies & a Lawsuit Accusing BBSI of "Cooking the Books"
Results within a BBSI statutory insurance subsidiary show deteriorating growth, earnings, and a miniscule reserve position. These results filed with state insurance regulators are inconsistent with reported consolidated trends. Ecole Insurance, which is wholly owned by BBSI, discloses contact information and addresses that do not appear to match any of BBSI's disclosed offices. Further, it appears Ecole shares an address with a Home Warranty Insurer, while listing a "Statutory Statement Contact" that appears to be a Beecher Carlson employee based in Hawaii. Further adding to our overall suspicion, a recent lawsuit filed by a 10-year branch manager accuses BBSI's CEO and the company of "manipulating the bottom line to avoid paying bonuses to managers," and "effectively 'cooking the books' to create inflated profit margins to entice interest in BBSI stock in violation of SEC regulations." We have been unable to corroborate these accusations, however taken with numerous other management misrepresentations that we believe exist, the litigation raises incremental flags.
9) California Workers' Compensation Destruction (brief background) - The California workers' compensation market has a treacherous history, with numerous stock market examples of investor losses in companies tied to this market. In the last downturn, carriers representing nearly 1/3 of the market failed due to significant reserve issues.[iii] More recently, investors in TWGP, MIG, EIG, and QBE AU have experienced steep losses following reserve issues tied to California workers' compensation. We believe BBSI investors will follow in these footsteps.
10) Deterioration of California Loss Trends Should Pressure BBSI - California workers' compensation insurers have reported a deterioration in underwriting results. A recent state insurance authority report found ominous trends in frequency and severity of loss costs. EIG recently took a large reserve charge related to its California workers' compensation business, warning, "We believe these [deteriorating] trends are an issue for us and for any workers' compensation insurance company doing business in California." BBSI has 74% of net revenues in California, with a heavy risk concentration in the exact areas experiencing increasing adverse claim trends.
11) ObamaCare & California State Fund = Risk of Large Client Departures and Negative Growth - It is unclear if the employer mandate under the Affordable Care, which goes into effect 1/1/15, will define large employers (50 or more) at the PEO level or the client level. If at the PEO level, we believe BBSI could lose a significant number of its clients. We are unable to reconcile BBSI's assertion that a high percentage of its clients offer healthcare. Our rudimentary analysis leads us to believe management may be taking liberties with certain qualitative commentary. After nearly eight years of contracting premiums and ceding market share, the California State Fund appears to be increasing its competitive positioning. After a major restructuring and new tiered pricing, California's largest workers' compensation insurer grew premiums by 23% in 2013. With a more competitive State Fund, insurance companies and PEOs focused on the low end of the market (like BBSI) should find growth much more challenging.
12) Normalized Valuation Suggests Substantial Downside - Sell-side analysts and investors utilizing cash flow and/or EV/EBITDA multiples to value BBSI are fundamentally erring in their valuation approach. These irresponsible valuation methodologies, which ignore the long-tail of workers' compensation coverage and are wholly inconsistent with traditional insurance valuation analysis, have been used to justify BBSI's lofty valuation. If we apply aggressive growth assumptions, generously assume BBSI can lower its fronting costs from the implied Q2'14 levels, and apply a 15% premium to the earnings multiple of a comparable insurance group, BBSI would trade at $29.00 per share, representing 50% downside. Our $29.00 fair value estimate assumes none of the myriad of long-tail risks discussed in this report materialize, which could create substantially more downside to our $29.00 estimate.
[i] Todd Krug vs. Barrett Business Services Inc. (14-2-00405-6)
Disclosure: The author is short BBSI.