Today we share a follow-up to our original BBSi report. We believe the analysis herein is even more impactful than our original report. Below are the highlights of our second report, which concludes BBSI may have as much as a $135 million funding gap (as well as revealing another crippling reserve charge is likely). Our analysis, based on a plethora of new disclosures and data points suggests an updated fair value for BBSI is between $0.00 and $8.76 per share, representing 65% to 100% downside.
Our full report can be found here: tiny.cc/5885ox
Barrett Business Services (NASDAQ:BBSI) has suffered a precipitous stock price decline over the last two months as the confession process has begun. Despite a stock price down nearly 75% from its highs, we believe the risk speculating in BBSI's common stock has never been higher. Simply put, a $100 stock that goes to $25 generates a smaller percentage loss than a $25 stock that goes to $0. Uninformed investors/traders appear to have fallen victim to the dangerous temptation of assuming the worst is behind BBSI, declaring the bottom is in, the bounce is at hand, or as the irresponsible sell-side has proclaimed - the decks have been cleared. This follow-up report, based on new information and disclosures since our first report, unequivocally concludes the worst has yet to come for BBSI.
On 9/16/14, we shared a lengthy BBSI report titled, "Barrett Business Services (BBSI): A Tick-Tick-Ticking Time Bomb" (it can now be printed to accommodate many requests).[i] Following BBSI's third quarter financial release and disclosure of an $80 million reserve charge (10/28/14), we briefly shared updated thoughts in "BBSI: Tick-Tick Boom."[ii] In short, substantial downside still exists and making money owning BBSI's stock appears to be effectively capped.
It is our opinion that the $80 million reserve charge is just the beginning. Based on management's recent disclosures, our analysis suggests BBSI will be required to take another reserve charge of at least $55 million. We believe the company is not only aware of this probability, but management's bizarre actions are an attempt to prop up the stock price long enough to minimize the dilution of an eventual distressed equity raise. (To this point, we are admittedly surprised BBSI's management has not yet "hit the road" to meet with institutional investors).
Our first report accurately analyzed BBSI's systematic reserve deficiencies. In this report, we provide an equally concise, and perhaps irrefutable argument supporting our belief that another reserve charge is on the horizon. We can not stress enough that the recent $80 million charge does not "clear the decks" as some interested parties have argued. In fact, per BBSI's own admission, the $80 million charge only targets reserve deficiencies for accident years 2012 and prior, leaving the severe workers' comp under-accrual from 2013 and 2014 unaddressed. This begs the question - Did BBSI ignore Willis' recommendation of a larger reserve charge that would have covered the 2013/2014 under-accruals, but also would have effectively wiped out the common equity in the process?
The same sell-side analysts that were politely excused from prior culpability (due to their lack of insurance expertise) have failed to think independently, suggesting the bad medicine has been taken. Our analysis herein unequivocally concludes BBSI is still massively under-reserved. By extension, a common equity raise appears to be a question of "when" not "if" which explains management's token buyback, dividend increase, and immaterial insider buying. In this report, we cover a number of topics, including:
1) BBSI Appears Unprofitable; Another Large Reserve Charge Is Inevitable (& Management Knows It); ACE Risk Grows
BBSI's reserve charge only addresses reserve deficiencies through calendar year 2012. As such, 2013/2014 reserves require significant strengthening. Based on an accident year model allocating the $80 million reserve charge and prior period development, we estimate BBSI's core business lost money every year between 2009 and 2012.Our analysis found the strengthened 2010 - 2012 reserves are approximately 45% and 26% higher than 2013 and 2014 reserve levels respectively. To bring 2013/2014 reserve levels to parity with 2010 - 2012 reserves, we estimate another $70 million charge is required. If BBSI management took the 2013/2014 reserves to a level consistent with updated accrual guidance, a $55 million charge would be required. We believe management's carefully worded press release and prepared remarks on its Q3'14 call means the actuarial rigor used to establish accident year reserves for "2012 and prior" was abandoned for determining 2013/2014 reserves. While management may try to buy time, hoping the actuarial data magically improves, we believe ACE may reconsider the fronting agreement in the interim. BBSI has changed materially since the fronting agreement was announced. Further, ACE's trusted partner Willis was used for the reserve study (as we predicted), suggesting ACE may not be comfortable with BBSI's reserves/underwriting. In our opinion, BBSI would likely go into run-off should ACE non-renew its fronting agreement.
2) Debt Alone Can Not Bridge BBSI's Funding Gap, Which Appears Much Larger Than Disclosed
BBSI is required to collateralize its $80 million reserve charge on a dollar-for-dollar basis to stay in compliance with State requirements. Under new law, California regulators have the discretion to require a security deposit greater than 100% of reserves in cases resembling BBSI. Management has proclaimed $32 million of the required funding can be met through a tax refund. But based on our analysis, the anticipated refund (40% of the $80 million charge) represents 55% more than the $20.7 million of cash taxes BBSI has paid since 2009. Insurance companies are typically limited to debt-to-capitalization ratios of 20% to 25%. Should Wells Fargo view BBSI in the same vein as other insurers, BBSI's debt capacity may only be $8.5 to $11.5 million. If BBSI somehow raised $65 million of debt (on just $34.4 million of equity), its leverage ratio would be 65%, higher than any solvent insurance company we could find. BBSI's 2014 cash flow has failed to cover the required funding of the ACE trust account. Year-to-date, BBSI has contributed $31.1 million to the ACE trust account representing more than 100% of its already overstated cash flow. We believe an additional $20 million to $50 million is needed to fully collateralize the original ACE funding agreement. The ACE funding burden will be concurrent with the State level funding requirements on legacy reserve levels, at the same time BBSI will also be struggling to fund current and future reserves dollar-for-dollar. According to BBSI management, the company has $15 million of unencumbered cash, $14 million on an undrawn credit facility, and our estimate of a $21 million tax refund from cash taxes paid. We estimate BBSI has $185 million of near-term capital needs with only $50 million of identified sources. The result is a $135 million capital hole. Considering the expected hole, we find management's actions in the wake of the reserve charge irrational and irresponsible. As recently as September 2014, BBSI wasted precious capital to buy back stock at prices nearly 100% higher than the current price. Instead of prudently rightsizing exposure through re-underwriting and re-pricing its business, BBSI management announced it would grow same store sales in 2015. Finally, BBSI increased its quarterly dividend by 22% (which it will not be able to cover based on our 2015 estimates), despite requiring $80 million of near-term capital.
3) Irrationally Aggressive Pricing and Outlandish Marketing Claims
We believe BBSI has materially underpriced its workers' compensation insurance to grow in a highly commoditized industry. BBSI's own marketing materials claim to offer "lower workers' compensation premiums [due to] aggressive claims management." Amazingly, we have obtained BBSI marketing slides stating their California loss ratio is just 10% - 14%. This compares to standard market carrier loss ratios between 50% and 75%. BBSI's own marketing materials suggest it would be 600% - 700% more profitable than the industry average cited by the California Department of Insurance. Further, we question what BBSI means when referring to "aggressive claims management." Public lawsuits shed insight into the challenges individuals have had obtaining settlements, while also leading us to question why BBSI accepted a workers' compensation client one year after being charged with defrauding the California State Compensation Insurance Fund.
4) Stock Still Significantly Overvalued on Estimated 2015 EPS
At a 12x earnings multiple on our generous set of 2015 earnings estimates, BBSI's fair value would be $8.76 per share. Our estimates generously exclude increased costs associated with changes to the ACE fronting agreement (which mathematically appears impossible). With the combination of another reserve charge looming for 2013/2014 business, uncertainty about its funding/capital ratios/leverage, and the pending ACE fronting agreement renewal, we see numerous scenarios, and a growing probability that BBSI's equity will be worth zero.
IMPORTANT Disclaimer - Please read this Disclaimer in its entirety before continuing to read our research opinion. You should do your own research and due diligence before making any investment decision with respect to securities covered herein. We strive to present information accurately and cite the sources and analysis that help form our opinion. As of the date this opinion is posted, the author of this report has a short position in the company covered herein and stands to realize gains in the event that the price of the stock declines. The author does not provide any advanced warning of future reports to others. Following publication of this report, the author may transact in the securities of the company, and may be long, short, or neutral at any time hereafter regardless of our initial opinion. To the best of our ability and belief, all information contained herein is accurate and reliable, and has been obtained from public sources we believe to be accurate and reliable. However, such information is presented "as is," without warranty of any kind - whether express or implied. The author of this report makes no representations, express or implied, as to the timeliness or completeness of any such information or with regard to the results to be obtained from its use. All expressions of opinion are subject to change without notice and the author does not undertake to update or supplement this report or any of the information contained herein. This is not an offer to buy any security, nor shall any security be offered or sold to any person, in any jurisdiction in which such offer would be unlawful under the securities laws of such jurisdiction.
Disclosure: The author is short BBSI.