Insperity, Inc. Q2 FY2020 Earnings Call

Good afternoon. My name is Jerome, and I'll be your conference operator today. I would like to welcome everyone to the Insperity Second Quarter 2020 Earnings Conference Call. At this time, I would like to introduce today's speakers. Joining us are Paul Sarvadi, Chairman of the Board and Chief Executive Officer; and Douglas Sharp, Senior Vice President of Finance, Chief Financial Officer and Treasurer. At this time, I'd like to turn the call over to Mr. Douglas Sharp. Mr. Sharp, please go ahead.

Thank you. We appreciate you joining us. Let me begin by outlining our plan for this evening's call. First, I'm going to discuss the details behind our second quarter 2020 financial results, which were strong considering the current economic environment brought upon by the pandemic. Paul will then comment on the key drivers behind our Q2 results and our outlook for the remainder of the year. I will return to provide our financial guidance for the third quarter and an update to the full year 2020 guidance. We will then end the call with a question-and-answer session. Now before we begin, I would like to remind you that Mr. Sarvadi or I may make forward-looking statements during today's call, which are subject to risks, uncertainties and assumptions. In addition, some of our discussion may include non-GAAP financial measures. For a more detailed discussion of the risks and uncertainties that could cause actual results to differ materially from any forward-looking statements and reconciliations of non-GAAP financial measures, please see the company's public filings, including the Form 8-K filed today, which are available on our website. Now let's discuss our second quarter results in which we achieved $1.54 in adjusted EPS, an 86% increase over Q2 of 2019; and adjusted EBITDA of $92 million, an increase of 62%. Average paid worksite employees declined by just 1.8% from Q2 of 2019 compared to our forecast of a 1% to 5% decline that took into account the impact of the COVID-19 pandemic on our clients and prospects. All three drivers, including worksite employees paid from new sales, client retention and net losses in our client base from layoffs and hiring, were better than expected. Worksite employees paid from new client sales were approximately 20% above forecasted levels driven by a 15% increase in trained Business Performance Advisors and success in our mid-market segment. Client retention held up at our historical high level of just over 99% during Q2. This points to the financial strength and actions taken by our clients during the pandemic and our quick and effective response to assist our clients with our premium level of HR services. Net losses in our client base in Q2 were lower than expected as the level of worksite employees laid off, returning to work from furlough and general hiring were all favorable. This was particularly the case in the month of June. In a few minutes, Paul will share the details on the actions we've taken recently to assist our clients and provide thoughts around more recent trends in our updated 2020 worksite employee outlook. So let's move on to gross profit, which increased by 27% over Q2 of 2019. These results included lower-than-forecasted benefits and workers' compensation costs partially offset by our decision to provide comprehensive service fee credits to our clients. Lower benefit costs were primarily due to lower utilization, especially lower levels of elective health care procedures, some of which is expected to be offset in subsequent quarters with the resumption of deferred care and future COVID-19 costs. Lower workers' compensation costs were primarily a result of the effective management of claims incurred in prior periods and largely unrelated to the pandemic. Due to the structure of our workers' compensation program, any reduction in the number and severity of workers' compensation claims associated with the work-from-home status of many of our clients and employees would likely impact our cost in later periods as these claims develop over time. During the quarter, we proactively engaged with our vendors in successfully negotiating savings to support our clients through this difficult period. As a result, we provided a comprehensive service fee credit to our clients based upon their worksite employee levels at June 30. These credits totaled approximately $12 million and were accrued in the second quarter. Also, under the CARES Act and Family First Acts, clients were able to take advantage of payroll tax deferrals and credits offered through government stimulus packages. These deferrals and credits totaled approximately $45 million during Q2 and were reported as both a reduction to revenue and direct costs. So in total, these two items reduced Q2 reported revenues by approximately $57 million and gross profit by approximately $12 million. Second quarter operating expenses increased by 9% and included continued investments in our growth, including costs associated with the increase in the number of Business Performance Advisors. Other corporate employee headcount has remained level over the first half of this year even though HR demands have increased with the pandemic and its impact on the economy and a number of HR issues, including diversity and inclusion. Second quarter compensation costs included an acceleration in the timing of a portion of our corporate employees' annual incentive compensation to reward them in a period of increased service demands. Additionally, Q2 operating costs included an increased paid time-off accrual associated with higher-than-normal unused vacation hours during the pandemic. Now these expenditures were partially offset by cost savings in other areas including travel, training and business promotion costs. Our effective tax rate in Q2 came in at 27%, and we expect a similar rate over both the latter half of this year and for the full year 2020. Our strong financial position and liquidity continued to improve over the first half of 2020 in the face of the challenges and dynamics of the pandemic. Adjusted cash totaled $269 million at June 30, up from $108 million at December 31, 2019, while borrowings totaled $370 million at the end of Q2, up from $270 million at December 31, 2019. Over the first half of this year, we have repurchased 879,000 shares of stock at a cost of $61 million, paid $31 million in cash dividends and invested $39 million in capital expenditures. Now at this time, I'd like to turn the call over to Paul.

Thank you, Doug, and thank you all for joining us. Today, I'll begin with a discussion of our efforts over the recent quarter to support our small and medium-sized business clients throughout the historic disruption arising from the pandemic. Secondly, I'll cover our view of the dynamics driving our expectations over the balance of the year for growth and profitability. And I'll finish my remarks with some thoughts about the long-term effect on demand for Insperity services, which represents a silver lining in the cloud of COVID-19. This quarter was an eye-opener in many ways, including highlighting the absolute necessity and the tangible value of a sophisticated HR function for small to medium-sized businesses. The unexpected events that played out over the course of the quarter cast a spotlight on the HR department, which, of course, is what Insperity is to our clients. The sequence of events beginning with the health crisis evolved into economic disruption and the transformation to working from home, followed by the emotionally charged dynamic of prolonged stay-at-home orders and political and social unrest. When you add in federal, state and local legislative and regulatory responses with new obligations and opportunities for businesses, you have a monumental challenge and opportunity for an HR services provider to demonstrate value to clients. Insperity Workforce Optimization has long been the most comprehensive business service offered in the marketplace, and our competitive distinction is the breadth and the depth of our services and the level of care of our service providers. Our clients were relying on us to help them work through decisions that directly affected the livelihood of their businesses, employees, and families. Our service teams continue to serve our clients and worksite employees with genuine care and excellence in an unprecedented time of need and constant change. In more than 30 years, I've never seen a quarter where clients experienced more of what we are designed to offer in such a compressed time period. The effort put forth was exceptional and could have only been delivered by the combination of an amazing team and an incredible culture like we have at Insperity. The workload across the company escalated substantially with call volumes and length doubled, service interactions tripled and a long list of other services spiking. HR solutions were required for the myriad of issues businesses were facing, including layoffs and staffing strategies, PPP loan application forgiveness and reporting, work from home, return to work, FICA deferral and diversity and inclusion, just to name a few. Allow me to say we could not be prouder of our staff across the board for the way they stepped up and delivered on our mission to help businesses succeed so communities prosper through a very challenging period. Now in addition to passing this service stress test with flying colors, we also were able to see our business model perform well under the pressure of these unprecedented events. We were pleased with the dynamics across the business from sales and retention to pricing, direct cost and operating expenses. On our last call, we indicated our objective in new account sales operating in this virtual selling environment would be to fall within a range of 60% to 80% of our original 2020 pre-COVID sales budget. As you may recall, the sales budget is the internal metric we use to monitor and track performance in our sales organization. Our entire sales organization, both core and mid-market, performed remarkably well, achieving total booked sales above 70% of our original 2020 pre-COVID sales budget and in the higher end of our revised targeted range. As a reminder, once the sale is booked, our service teams work to onboard those clients and actually generate revenue as paid worksite employees. In this environment, client retention may also be a concern due to an increase in the business failure rate in the marketplace at large. As Doug mentioned, our client retention has remained solid, reflecting the strong client base we have and demonstrating the benefit of our strategy of targeting the best small and mid-sized businesses onto our premium services platform. Another stress test during a period like this was around pricing of our services on both new and renewing accounts. It is certainly another credit to our staff and further validation of the value of our services that our standard pricing on our book of business did not reflect unusual pricing pressure in this environment. We were also very responsive to the immediate financial needs of our clients by providing a COVID-19-related service fee credit. During the quarter, we worked with vendors and negotiated $12 million in fee reductions to pass along to clients. We felt it was important to act quickly in this regard and get the funds to clients as soon as possible, and clients will begin seeing this credit on invoices starting this week. Another area to evaluate during this unusual time was the matching of price and cost on our primary direct cost items, including payroll taxes, workers' compensation, and employee benefits. As I mentioned, pricing has remained on track. And although our quarterly direct cost pattern has changed, we anticipate a strong year overall at the gross profit line. So we have navigated the disruption and the immediate aftermath of the pandemic and related events of Q2 successfully, and our business model demonstrated substantial resiliency. Now in order to determine our expectation for the balance of the year, we need to zero in on the most recent behavior of our clients, particularly in layoffs and new or rehires in the base, and consider the economic outlook for small business. Now in the second quarter, layoffs due to COVID drove a 6% reduction in paid worksite employees from March, reaching a low point at the end of May. Now since then, we've recovered approximately 40% of this reduction primarily due to the return to work of just over 50% of furloughed employees. At the same time, approximately 17% of furloughed or temporarily laid off employees have been reclassified to permanent layoffs. So the number of potential rehires has been reduced by two-thirds. At this point, the rate of both layoffs and furloughed employees returning to work has moderated considerably. So determining what happens in the near term and the net change in employment in our client base is somewhat of a toss-up. On one hand, it seems the small to medium-sized business community is adapting and dealing well with the new realities they're facing. We believe our client base has been particularly impressive in this regard. However, the continuing spread of the virus and the corresponding economic uncertainty may temper the rebound we have seen recently. Also, in our experience, there is sometimes a pause or hesitancy in decision-making with the uncertainty of an upcoming election, which may weigh in over the second half of the year. We do expect new account sales to ramp up over the last half of the year. However, most of the booked sales in Q4 typically do not become paid worksite employees until Q1 of the following year. These sales would contribute to growth in 2021 but not contribute significantly to this year's results. With this backdrop, our guidance for growth is somewhat conservative over the balance of the year. Although the pandemic-driven circumstances make us appropriately cautious about the near term, recent events have made us even more bullish about the long-term prospects for Insperity. Our outlook for profitability over the last half of the year also has an appropriate measure of conservatism built in. The wild card here is in our direct costs and particularly our health plan where some portion of lower cost experienced in Q2 is expected to shift to Q3 and Q4. This creates an unusual quarterly pattern to our profitability for 2020, shifting more of the profits to the first half than usual. With this in mind, I believe it's very important for investors to look at the range of expectations for the full year 2020 in context of the pandemic and focus on how we are positioned for 2021. Our full year guidance for 2020 implies a range of minus 1% to minus 3% unit growth in paid worksite employees. We expect a range of adjusted EBITDA growth that straddles the level we achieved last year at minus 6% to plus 2%. So the big picture for the full year 2020 is layoffs due to COVID, and the economic shutdown is expected to be partially offset by higher gross profit per worksite employee and lower operating expenses than our original budget. So while we're continuing to focus on meeting the intense need of our client base in the current environment, we are also looking to the longer term and the straightest path to regaining our growth momentum in 2021 as COVID-19 moves further into the rearview mirror. We believe we are very well positioned for growth as we look ahead to next year. The front of our growth engine is the number of trained Business Performance Advisors, which is currently at the highest level in our history. We have deliberately continued to invest in this team throughout this economic disruption due to the likelihood of a quicker and stronger growth surge once the uncertainty diminishes. We also believe we have an opportunity to hone our marketing message, utilizing the recent positive client experiences, and we intend to increase our marketing spend in the fall to drive leads and test this new messaging. In many ways, the unexpected and unusual developments of the last quarter validated the need for our services and the distinct advantage we provide to improve the success equation for small and medium-sized companies. Even though the pandemic has been quite a challenge, over the long term, we believe this experience will serve to increase demand within the small to medium-sized business community for Insperity services in the years ahead. At this time, I'd like to pass the call back to Doug.

Thanks, Paul. Now let me provide our guidance for the third quarter and an update to the full year 2020. With the first half of the year behind us, we have more visibility as to the impact of the pandemic on our business and have seen signs of gradual improvement as businesses have started to reopen and employees have gradually returned to work. However, a high level of uncertainty associated with the pandemic, its impact on the economy and any further government stimulus packages continues to exist. The current political environment and upcoming election adds another element of uncertainty. Our guidance intends to take this into account and continues to reflect a wider range of possibilities than that provided in the past. Based upon the details that Paul just shared on our expected worksite employee levels, we are now forecasting a 1% to 3% decrease in the average number of paid worksite employees for the full year 2020. This is a substantial improvement over our previous guidance of a 1% to 6% decrease and reflects the more favorable starting point for the second half of the year. The low end of this guidance assumes a persistent level of pandemic cases, continued economic disruption, and ultimately, a recurrence of layoffs in our client base, exceeding both new hires and furloughed employees returning to work. The high end of our paid worksite employee guidance assumes a gradual improvement in conditions associated with the pandemic and its impact on the economy and, therefore, a nominal level of growth in our client base through both furloughed employees returning to work and general hiring. For the full year 2020, we are raising our earnings guidance and now forecasting adjusted EBITDA of $235 million to $255 million, ranging from a decrease of 6% to an increase of 2% when compared to 2019. This compares to our previous guidance which ranged from a decrease of 14% to flat for 2019. A component of this revised guidance is a further shift in the expected timing of healthcare utilization during the pandemic. As I mentioned a moment ago, the level of Q2 benefit cost savings largely tied to lower utilization and fewer nonessential procedures came in significantly better than our previous expectations. We expect that a portion of these nonessential procedures were deferred and some will shift into the latter half of the year, including costs associated with participants with chronic conditions that miss treatment. We also continue to expect ongoing COVID-related testing and treatment costs. As for our operating costs, we expect continued cost savings in various areas while operating in the current pandemic environment. As we are ahead of plan on the growth in Business Performance Advisors, we intend to grow BPAs modestly over the remainder of 2020, while we intend to continue to hold our other corporate headcount flat. We are forecasting for an increase in marketing costs associated with the upcoming 2020 fall sales campaign as we promote our premier HR services in this period of increasing demand. Finally, our updated earnings guidance assumes a reduction of approximately $3 million in net interest income from our previous guidance due to the recent decline in interest rates. As for the full year 2020 adjusted EPS, we are now forecasting a range of $3.67 to $4.04, up from our previous guidance of $3.19 to $3.86. Now as for the Q3, we are forecasting average paid worksite employees in a range of 227,500 to 230,000, which is a small sequential increase over Q2. We are forecasting adjusted EBITDA in a range of $29 million to $38 million and adjusted EPS in a range of $0.37 to $0.54. Now at this time, I'd like to open up the call for questions.

Your first question comes from the line of Tobey Sommer from SunTrust.

Paul, I'm interested in your perspective on how this sort of recession and pandemic have played out with respect to you being able to kind of pull the playbook that you had thought you would implement in the next recession and sort of what you've done to deal with the situation currently. It looks like the BPAs are up substantially. That's something you had hinted that, but how about the cost structure and other things like that?

Yes. Thanks, Tobey. We have kept an eye on that as we've gone through this. This was more an abrupt change in reduction layoffs that you would typically find from a normal recession. But this also came with a more significant need for immediate HR support. So we have kept our corporate staff even with where we were at the time even though there was the 6% reduction in the worksite employee base because the workload, the volume has been really incredible. We've really been able to help our customers in amazing ways, but our people obviously have been really putting out a tremendous amount of extra effort. We also think that as we see how we bounced back about 40% from that bottom already and have the organization in place to grow in the very near future, even though there are some gives and takes about this next quarter or two, we think we're positioned very well for a substantial rebound in regaining our growth momentum earlier than you normally would if we didn't have this ongoing investment in our BPA team. And we're also going to look at really invigorating our marketing effort in the fall to kind of double down on that strategy. So we have followed our game plan, I think, pretty much. The thing that was a little bit different was such an increase in demand for the services because of the nature of the events that occurred.

That makes sense. If I could pull back the aperture and look a little longer term with my follow-up, what does this do to your thinking about this year's fall campaign and whether you can try to slingshot the growth as early as next year? And thinking about you and the industry providing a lot of value to sort of your customers as a category, does this change the way you think about the addressable market or the rate of growth over some sort of maybe 5-year period for the company?

Yes, it truly does. I'm really excited about the chance to use real, concrete examples from this situation in our discussions, advertising, marketing, and storytelling to potential clients in the market. I believe that many businesses, particularly those not utilizing our services, felt a significant need and faced challenges. As we enhance our ability to share our story and transform what happened into our marketing messages and sales strategies, and facilitate conversations between current and potential clients, whether through videos or referrals, I genuinely think we will look back and see a notable increase in demand. I hope we can better communicate our message and value, which is crucial in our field. This will support not only our growth rate but also our pricing and service model, all of which are interconnected in terms of value. I'm very optimistic about this as we move past the current situation.

Your next question comes from the line of Jeff Martin from ROTH Capital.

Can you hear me okay?

Yes, we can.

Okay. Great. I was wondering if you could kind of walk us through the cadence throughout the quarter in terms of monthly change. Obviously, April was the bottom, but you alluded to briefly May somewhat. But in terms of June and July, what have you experienced in terms of sales efficiency as well as headcount within the client base?

Yes. In my earlier comments, I mentioned that since March, we have seen a 6% decrease in paid worksite employees by the end of May, and about 40% of that figure has recovered since then. We are not quite halfway back to the March numbers, but we are making progress. Regarding new sales in the virtual selling environment, we reviewed our initial budget and anticipated what we could achieve early on. We set a target for the last three quarters of the year to land between 60% and 80%. I initially expected us to be closer to 60% in the second quarter, with potential to reach the higher end later in the year, but we actually surpassed 70% in the second quarter. We feel confident moving forward, and I believe we are in a strong position to perform well given the current circumstances.

Okay. And then in terms of the middle market, is that an increasingly attractive area to focus given the recessionary environment we're in? And if so, what strategically are you doing to shift more to the middle market?

Yes. Even in our core markets, shifting towards larger customers has been a part of our strategy since the pandemic began. However, our mid-market has remained very stable throughout this time, considering that discussions typically take longer. We have maintained a strong pipeline, which continues to look promising this year. We did not experience significant negative disruptions in that area, as the sales cycle is inherently longer. Overall, our performance has been steady during this period, the pipeline remains strong, and everyone is making the right moves. Therefore, we are optimistic about the future of our mid-market segment.

Your next question comes from the line of Mark Marcon from Baird.

With regards to just what you're seeing from a geographic perspective, are any of the flows that you're seeing in terms of worksite employees or engagement in terms of new business tied with the various geographic surges of the virus? In other words, did you see stronger performances in June and July out of the Northeast relative to, say, Texas and California? Or any sort of correlation from that perspective.

Yes. If we examine the layoffs and return to work concerning the furloughed employees by region, the trends are as expected. The layoffs were primarily concentrated in the West, which probably had the highest concentration, followed by the Northeast. In the other regions, the layoffs, as a percentage of total layoffs, were less than their share of total worksite employees. The same pattern is evident on the return-to-work side, with more returning employees coming from the same regions. Overall, it aligns with what you would anticipate by region.

Okay. Great. And then with regards to the healthcare cost, how much of the year-over-year improvement in terms of GP for WSE came from healthcare costs? Or how much were the healthcare benefits down on a year-over-year basis?

I think you could say, if you look at the gross profit, as I mentioned in my prepared remarks, sort of the outperformance in that area was due to both the benefit cost and the workers' comp, and more of the share of that came from the healthcare cost and the workers' comp.

And how are you thinking about that philosophically for the balance of this year and thinking about next year in terms of pricing, do you think that the majority of what was deferred during the second quarter is going to come through in the back half of this year? Is that part of the plan? Or are you assuming that 80% or 60% of what was deferred comes back?

Yes, I think the best way to look at that is to consider where we were a quarter ago. We had forecasted lower costs for the second quarter, expecting most of those costs to appear in the third and fourth quarters. However, we found that the lower costs were even more reduced than anticipated. We still predict a similar pattern with many of those costs returning in the latter half of the year. This indicates that our model is functioning differently this year compared to others. If you take a step back to assess the broader picture, instead of anticipating a total 3% trend for all benefit costs over the entire year, the absence of certain services in the second quarter, due to deferred elective surgeries and other care, likely reduced that trend by a couple of percentage points. What’s crucial for us is managing pricing and costs effectively over the long term. We are in strong position, having managed pricing well, and as I mentioned earlier, we’re not facing pressure in that area. We feel confident that there’s a good alignment between price and costs for these direct cost items. This is why we expect to achieve better gross profit results than initially projected and remain well-positioned for the future.

Great. Paul, I appreciate your comments. How does a potential 1% increase next year, rather than the expected 3%, affect your outlook, especially with some deferred elements still needing to catch up? What does this mean for your pricing strategy for next year?

Yes, we always need to pay attention to and manage this aspect. Internally, we evaluate this on a rolling 12-month basis. We continuously track the movements on both sides of the equation, including pricing, which factors in plan selection, plan design, and numerous elements that influence our pricing. We also consider client and employee selection, incoming new accounts, and the businesses we choose to renew. Many variables are at play here, and we work to ensure our pricing aligns with the longer-term outlook, rather than merely reacting to short-term trends influenced by the pandemic. We will monitor this month-to-month to ensure that our pricing and costs remain aligned.

Can you discuss some of the internal dynamics within your client base? Specifically, what are their sales commissions like, and how are they performing relative to their plans? How would you assess the current health of the situation, considering that trends bottomed in March, April, and May but have been improving since then? Are there any concerns about a few companies that seem to be struggling and might pull back now?

It has been quite interesting to observe the situation. We have accounted for a slightly higher rate of client terminations likely due to some financial difficulties and business failures. However, we haven't seen a significant amount of this, just a minor impact, which has been unexpectedly positive. Another metric we've been monitoring is the average pay for employees compared to the same period last year. This figure, which typically increases around 3% in a normal quarter, has actually decreased by about 1%. This change reflects that some of our clients had to adjust pay rates and revise their operating plans, though the overall impact was relatively small. While that trend was more pronounced among a smaller group of clients who made deeper cuts, the commissions also experienced a decline. For an extended period, commissions were quite high, but they have since decreased to an average increase of about 6% compared to last year, which I consider a strong performance in the current environment. I'm not entirely sure how to interpret this, except that it's encouraging to see, and we will monitor it closely. Another noteworthy statistic is that overtime as a percentage of base pay, which previously exceeded 10% during the economic boom, has dropped to around 7.5%. This change reflects a decline in capacity and demand, leading to a significant decrease in the need for overtime. We can see these effects taking place, but I must emphasize that our small and midsize business customers are incredibly resilient, innovative, and determined. It's rewarding to support them because they consistently find ways to persevere.

That's great to hear. Can you talk a little bit more about the marketing message? Because I mean, it's clear that you really came through for your clients during this period and there was a lot of utilization. So how much more are we going to spend? And what sort of return do you think we're going to see? And how quickly do you think that's going to take shape?

Yes. We're going to allocate enough resources to conduct a comprehensive test of the messaging. We’re not going to overspend without testing it first. We are planning to invest more and test various messages. There were some truly emotional moments during this time, where we observed how much our clients value their employees, striving to keep them employed and compensated. It was fascinating to witness. I would love to discuss the marketing message in more detail, but my marketing team would prefer if I didn’t. So, it's one of those situations where I can’t reveal too much.

There are no further questions at this time. I would now like to turn the call over back to Mr. Sarvadi. Please continue.

All right. Well, once again, thank you all for participating in our call and for your interest, and we look forward to seeing how things pan out over the next quarter and look forward to either having calls with people, Zoom calls, whatever the new mode of interaction is, with investors over this period. So thanks again for your participation.

This concludes today's conference call. You may now disconnect. Thank you.