Barrett Business Services Inc Q3 FY2023 Earnings Call

Good afternoon, everyone, and thank you for participating in today's conference call to discuss BBSI's Financial Results for the Third Quarter Ended September 30, 2023. Joining us today are BBSI's President and CEO, Mr. Gary Kramer; and the Company's CFO, Mr. Anthony Harris. Following their remarks, we will open the call for your questions. Before we go further, please take note of the Company's safe harbor statement within the meaning of the Private Securities Litigation Reform Act of 1995. The statement provides important cautions regarding forward-looking statements. The Company's remarks during today's conference call will include forward-looking statements. These statements, along with other information presented that does not reflect historical fact, 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 from those expressed or implied by the forward-looking statements. I would like to remind everyone that this call will be available for replay through December 1, 2023, starting at 8:00 p.m. Eastern tonight. 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.bbsi.com. Now I'd like to turn the call over to the President and Chief Executive Officer of BBSI, Mr. Gary Kramer. Sir, please go ahead.

Thank you, and good afternoon, everyone, and thank you for joining the call. We had another strong quarter, and I am pleased with our results. We continue to execute on our short-term and long-term objectives and we surpassed all of our internal controllable key performance indicators. Regarding our client and WSE stack, our controllable growth exceeded our expectations in the quarter as we continued to execute on our various strategies to increase the top of the sales funnel. I am pleased to say that we once again exceeded our expectations in new clients and in new worksite employees. As discussed previously, we have been able to sell and support larger clients with our upgraded technology, stack national PEO licenses, along with BBSI Benefits. This continues to progress favorably, and the average size of the clients that we are adding is larger than the average size of the clients that are running off. Regarding client runoff, our retention in the quarter was better than the prior year quarter and continues to remain stronger than pre-pandemic levels. I'd like to attribute that to the work we do with our clients and the value our teams provide. The result of all these efforts, or what I refer to as our controllable growth, is that we added approximately 4,300 worksite employees year-over-year from net new clients. This was partially offset by slower client hiring in the quarter. Our clients increased their workforce sequentially over the second quarter, but by less than we were forecasting. Anthony will provide more color for the portfolio by geography and industry. To summarize, we grew our worksite employees by 1%, which was slightly lower than forecast for the quarter as we sold and retained more business, but this was partially offset by slower-than-anticipated client hiring. Moving to our staffing operations, our staffing business declined by 25% over the prior year quarter and was slightly better than we anticipated. We mentioned previously that we repriced the portfolio and jettisoned clients where we were not achieving an adequate return. We also shifted our strategy to recruit for our PEO clients and placed 83 applicants in the quarter, which generated equal margin to our traditional staffing model but resulted in less top line revenue. We also experienced microeconomic factors, including supply and demand imbalances, which vary by geography. Moving to the field operational updates, we are very pleased with our entrance into new markets with our asset-light model. We have 14 total new market development managers that are in various stages of their development. They are doing well and largely achieving their goals of adding and servicing new clients and new referral partners and have a robust pipeline. Our results thus far are better than we expected and are exceeding our internal return hurdle rate, and we are actively recruiting for the next class. Regarding our product updates, we continue to execute on the sales and service of BBSI Benefits, our new health insurance offering. As a refresher, we rolled out our benefits offering in California in the second quarter and are now selling and servicing BBSI Benefits in every market where we operate. I am pleased to report that through October, we have 160 clients on our various plans with more than 3,500 total participants. Our value proposition is resonating well, and we are having success with small and large clients in white- and blue-collar industries, in every state we operate and with a diverse distribution channel. We are in the thick of the 1/1 selling season, and our business teams are offering BBSI Benefits to our existing clients as well as potential new clients. It is still too early to provide any definitive guidance, but we are pleased with our current pipeline. If we close the current opportunities that are in our pipeline at our historical benefits closing rate, then we are confident that this product will be accretive to earnings in 2024. Next, I'd like to shift to our view of the remainder of the year and the 2024. Our various sales strategies continue to increase the top of the sales funnel, our controllable growth exceeded our expectations every quarter this year, and that trend continued into October. Our qualified prospects at the end of the quarter were approximately 75% greater than the prior year quarter. If we close this business near our historical close rate plus close on our benefits opportunities, then we are setting ourselves up for a strong start to 2024. If there's no dislocation in the economy, and we close out the year in the manner I just described, we expect to see improved gross billings growth in 2024 over 2023.

Thanks, Gary. Hello, everyone. I'm pleased to report we finished Q3 with strong results as we continue to exceed our expectations for profitability and worksite employees added in the quarter for net new clients. Our overall gross billings increased 3% in Q3 '23 to $1.96 billion versus $1.91 billion in '22. We have achieved diluted earnings per share of $2.68 compared to $2.45 in the prior year quarter. PEO gross billings increased 3.3% over the prior year quarter to $1.94 billion, while staffing revenues decreased 25% over the prior year to $22 million. Our worksite employees grew by 1.1% in the quarter which was the result of adding more WSEs than expected from net new PEO clients, offset in part by slower hiring within our existing customer base. Looking at client hiring more closely, we have seen overall hiring trends stabilize in the quarter and increased modestly on a sequential basis, but the pace of hiring remains slower than historical trends and slower than expected. We continue to see this slowness primarily in the construction sector and most concentrated in our Northern California region. Average hours worked and overtime hours per employee have continued to stabilize in the quarter as well. Average billing per WSE increased 3.5% in the quarter, driven by higher average client wage rates, which remain resilient and which will continue to be a source of billings growth going forward. Looking at overall PEO gross billings growth by region versus the prior year third quarter, East Coast grew 12%. Mountain States grew 8%, Southern California grew 5%. The Pacific Northwest decreased by 3%, and Northern California decreased by 3%. As Gary discussed, staffing revenues are down year-over-year, driven by strategic shifts in our model and the current economic environment. That said, our staffing revenues increased sequentially and we expect this stability to continue through year-end. Our workers' compensation program continues to perform well and benefit from favorable claim frequency trends and favorable claim development. This strong performance has once again resulted in favorable adjustments for prior year claims. In Q3 '23, we recognized favorable prior year liability and premium adjustments of $2.2 million. This compares to favorable prior year liability of premium adjustments of $1.4 million in the third quarter of 2022. As a reminder, our client workers' compensation exposure is now primarily covered by our fully insured program with no retained liability by BBSI. Our gross margin rate improved in the quarter due to the cost savings from lower workers' compensation expense and our ongoing focus on pricing discipline. In addition, our profitability continues to benefit from cost management efforts that largely offset the impact of our ongoing investments in the launch of BBSI Benefits and our expanding team of market development managers. As a result, SG&A for the year continues to grow slower than the prior year and slower than our billings growth rate. Moving to investment income, our investment portfolios earned $2.3 million in the third quarter, up $700,000 from the prior year due to higher yields and more favorable cash flow timing associated with our current fully insured program. Our investment portfolio continues to be managed conservatively with an average duration of 3.5 years and average quality of investment at AA. Our balance sheet remains strong with $129 million of unrestricted cash investments at September 30 and no debt. Continuing under the Board's July 2023 repurchase program announced last quarter, BBSI repurchased $11 million of shares in the third quarter, to $64 million remaining available under the program. The Company also paid $2 million in dividends in the quarter and reaffirmed its dividend for the following quarter. Turning to our outlook for the year, we are updating our outlook to reflect our year-to-date results, and we now expect gross billings to increase between 4% and 5%, a slight decrease from the 4% to 6% in our prior outlook. And we expect average WSE to increase between 2% and 3% for the year, a slight decrease from the 2% to 4% in our prior outlook. We continue to expect gross margin as a percentage of gross billings to be between 3.1% and 3.15%, and we continue to expect our effective annual tax rate to remain between 27% and 28%. I will now turn the call back to the operator for questions.

Our first question comes from Jeff Martin with ROTH Capital Partners. Please proceed with your question.

Good afternoon, Gary and Anthony. Hope you are doing well. Wanted to dive into a little bit more on the sales funnel, what are some of the things you're doing differently this year versus years past, maybe that's leading you to hit your internal controllable targets?

We've been focused on the top of the sales funnel, actively refining our approach over the last couple of years to maximize our visibility. This includes targeting clients directly, working with referral partners, and engaging benefits brokers. It's not just a single solution; we've implemented various strategies during this time. We're now beginning to see positive results. In fact, as I mentioned earlier, our qualified prospects are up about 75% at the end of September compared to September of 2022. This translates to significantly more potential clients for Q4 and Q1. We have a lot of momentum in this area, and we're optimistic about the outcomes as we move into the next quarters.

And then remind us on the BBSI Benefits side, what's the investment this year and next year that you've got to essentially cover to become earnings accretive there? And then the second part to that question is, can you give us an update on some of the new referral partners that you've brought on board specifically for BBSI Benefit, would be helpful.

Sure. This is Anthony. Jeff, I'll take the investment question, and then Gary can speak to the referral partners. But we spent about $3 million of total expense investment to operate this program. So that's essentially the run rate we're at right now. Obviously, as it scales over time, that could change a little bit, but that's where we're at.

On the referral partner side, I don't have the exact number of new referral partners we brought in during the quarter, but we are consistently focused on attracting new partners. Our team is actively engaging with potential partners, and they are doing a great job at what we refer to as making new connections. As part of our strategy related to our total addressable market, we can now reach out to employee benefits brokers. Previously, they could refer clients to us, but we didn't have a product that fit their needs because it lacked health insurance. Now that we offer health insurance, we can connect with nearly double the number of employee brokerages available.

And then last one for me. In terms of growth drivers for next year, obviously, a rebound in hiring from clients would be a big one. But is the potential for workers' compensation rates in California, in particular, are you viewing that as a potential growth driver next year?

We're observing that some carriers are less aggressive than they used to be. While competition still exists in the marketplace, their approach has softened. There aren't any significant factors pushing accounts to market due to rate increases on the workers' compensation side. However, we do see some movement on the health insurance side, where clients are exploring options because certain markets are experiencing rate increases of over 20% for their medical coverage. This situation is encouraging some accounts to seek alternatives. On the workers' compensation front, rates are fluctuating within a range of plus or minus 2% to 5%. Currently, it's not a pressing issue that is pushing business to market, and we don't anticipate that changing.

Our next question comes from the line of Chris Moore with CJS Securities. Please proceed with your question.

Maybe just a quick follow-up. The $3 million incremental expense on health care. Some of that is in '23 and some in '24? Or where does that get placed?

Annual expense is in 2023, and we increased a little bit, but we were mostly fully staffed for the year. So, that's the approximate run rate for 2024 as well.

And maybe just one more on the health care side. So do you expect the ultimate penetration here to match the penetration of existing business, for example, 75% of the health care to be in California? Is it geography bias? Is there some other bias by type of employment? Just trying to kind of get your thoughts there.

As we are mastering our craft for benefits, we've had better success selling it into our installed base. So I think we said 160 clients that have enrolled through October, of those 160, 20% of those are new business. So that's new to BBSI. We wouldn't have brought those clients on to call that 30%, we would not have brought those clients on if we didn't have benefits. So that's allowing us to pick up additional business that we wouldn't have received. But as we're learning our craft, it's a little bit easier to sell it to your friends, right, in our clients. They know us well; they know the products we deliver; they trust us. It's a little bit of an easier sell to sell it into your installed base than to sell it to a new. But what we want to get to in the future is, after we sell through our installed base, continue to sell into new clients. But you can kind of see how this will ramp over time, right? We doubled the book on 7/1. We'll probably double it again on 1/1 as far as our portfolio of clients that buy the benefits, and then we'll see where it goes from there.

And just kind of big picture. Just trying to get a sense as to how much visibility you have in fiscal '24 as of November 1. Do you know much today that you didn't know three to four months ago? Just trying to get a better sense as to how you're seeing early '24.

We are optimistic about our pipeline of benefits opportunities. If we achieve our historical closing rate, we anticipate an accretive year for benefits in 2024 that will exceed the $3 million we plan to invest. We won’t provide specific numbers until we enter 2024, but we expect to generate more than what we spend. Additionally, the pipeline for our traditional non-benefits prospects is the largest we have seen at the end of Q3. If we continue executing our strategy of adding clients and WSEs as we have in the past two years, we feel confident about 2024. Even if our client hiring remains flat, we believe it will be manageable to achieve better gross billings in 2024 compared to 2023.

Our next question comes from the line of Vincent Colicchio with Barrington Research. Please proceed with your question.

Gary, site construction is a weak sector. If I remember correctly, that's been weak for some time. I'm curious, are you seeing that deteriorate?

No, we actually saw some recovery in Q3. Our clients increased hiring in Q3 compared to Q2. It was a small positive change, but I prefer a positive over a negative any day. We first noticed a slowdown in client activity around November and December of 2022. Then, there was a gradual recovery in Q1 and Q2 of 2023, and we observed a slow upward trend in Q3. Although it’s still early to make conclusions, particularly in the Bay Area, where we’re noticing improvements, we are hopeful that this trend continues to reverse.

And one clarification. Did you say the profits gained from staffing clients within PEO offset losses from clients that you shared in the staffing line?

This is a challenging situation to explain. Currently, we handle recruiting for our clients. When we complete the recruiting phase, say for $10,000, our clients hire someone and pay us that $10,000 as a recruiting fee, which represents our profit. We recognize that $10,000 as our sale and profit. In contrast, if this were a traditional staffing business, where the individual earned $75,000 in wages, we would include wages, taxes, and other costs in the revenue line, which would total around $100,000, while still making a $10,000 profit. This reflects a change in how we account for recruiting in staffing. Essentially, we're maintaining adequate margins on staffing, but we're not generating as much revenue as we previously did, nor are we accounting for the associated costs.

You mentioned staffing should grow sequentially. What is specifically driving that?

We experienced growth this quarter and expect modest growth in the next quarter. The increases will be small, not significant. However, we believe the major declines are largely behind us. The 25% revenue decrease now reflects a year-over-year comparison, but the current trend appears to be flat to positive. We're maintaining that trend. As Gary mentioned, the activity in staffing is encouraging, though it doesn't require large revenue increases, it is still contributing to some revenue and margins.

As you go after bigger clients and the competitive, I think the competition is a little different. Are you seeing competitive pressures increased in the current environment?

No, no more than normal. I mean, there's competition everywhere. But with our product and our people in the field, it's really our differentiator, right? We can talk about all these different tools that we have as far as workers' comp or health insurance and yada, yada, yada, but the people in the field doing the work and being there with the business owner, that is the core product, and that's what we're able to sell in the market. That's what keeps the business on the books. That's the one that the clients truly find the value in is in those units.

Our next question comes from the line of Marc Redick with Sidoti & Company. Please proceed with your question.

I wanted to follow up on the construction commentary. If I recall correctly, there were factors outside of our control that affected the timing compared to last year. Specifically, there were weather-related impacts in the fourth quarter and into the first quarter. Could you discuss what you observed during that time and how we might see those effects this time around?

Yes, we noticed a decline in our clients during Q4, which continued to escalate into Q1. This coincided with a significant increase in interest rates, a shift in the macro economy, and severe weather conditions in Northern California. All of these factors combined created a challenging environment for us. From our perspective, it was difficult to predict the outcome. We anticipated a recovery in Q2 of 2023, but it didn’t materialize. However, we are now optimistic because the clients who had reduced their workforce have begun to hire again in Q3. We observed growth in our client base during that quarter, which contributes to our positive outlook after three quarters of decline followed by a rebound in employment numbers in Q3 this year.

I was curious about what you're observing with the banking and finance customers. Given the challenges we've highlighted that are beyond our control, can you update us on the current situation?

I mean we really weren't that affected by the banking crisis a year ago. We don't have a lot of direct clients in that space. Obviously, all of our clients use banking services. So, we were watching very closely to see if there are impacts on our clients. It wasn't a prevailing pain point beyond a few anecdotal stories. So, we recovered very quickly from that. I mean for our clients in the blue- and gray-collar space, the biggest headwind has been construction and really driven by the cyclical nature of that with interest rates.

And then the last one for me. I was wondering if you could circle back to benefits for a moment. Are there any particular client verticals or any particular customer groups that have responded more positively than others? Or are there any differentiations that you're seeing as to those who are being part of that add? And then also maybe you could talk a little bit about the sales cycle and maybe how that's played out compared to what your expectations were.

We're mainly focusing on our existing customers, which means we're not entering any new markets. However, we are seeing positive results in all states, and our clients are keen to purchase our product. We're confident in its effectiveness across the board. Additionally, we're experiencing success in new markets, with our market development managers generating about 80% of their new business by selling benefits. This optimism stems from their ability to explore various products and develop strategies to penetrate these markets, and I'm really proud of their efforts. Generally, in these new markets, we notice more white-collar growth as these individuals tend to be more comfortable with the processes and connections we've established since we often hire people familiar with the industry or similar fields. We're optimistic about our growth there. Regarding the sales cycle, we understand this process isn't quick; it usually takes about three to four months from selling to completion. This timeline includes underwriting and employee enrollment, requiring careful management to ensure everything is done accurately. We wish we could provide a clearer forecast right now, but we're in the thick of the first of January season. Most clients will make their purchasing decisions around mid-to-late November, aiming to start enrollments by Thanksgiving or early December, wrapping everything up by mid-December. Until we finish those enrollments, we won't have a precise estimate of our sales performance for the season.

There are no further questions in the queue. I'd like to hand the call back to management for closing remarks.

Thank you. Just again, I want to thank all the BBSI professionals for another great quarter on controllable growth. Everybody is doing a great job, and we appreciate everything you do for the organization. Thank you everybody.

Ladies and gentlemen, this does conclude today's teleconference. Thank you for your participation. You may disconnect your lines at this time, and have a wonderful day.