Barrett Business Services Inc: Form 10-Q for the period ended Sep 30, 2023

General

Company Background Barrett Business Services, Inc. (“BBSI,” the “Company,” “our” or “we”), is a leading provider of business management solutions for small and mid-sized companies. The Company has developed a management platform that integrates a knowledge-based approach from the management consulting industry with tools from the human resource outsourcing industry. This platform, through the effective leveraging of human capital, helps our business owner clients run their businesses more effectively. We believe this platform, delivered through a decentralized organizational structure, differentiates BBSI from our competitors. BBSI was incorporated in Maryland in 1965.

Business Strategy Our strategy is to align local operations teams with the mission of small and mid-sized business owners, driving value to their business. To do so, BBSI:

• partners with business owners to leverage their investment in human capital through a high-touch, results-oriented approach;
• brings predictability to each client organization through a three-tiered management platform; and
• enables business owners to focus on their core business by reducing organizational complexity and maximizing productivity.

Business Organization We operate a decentralized delivery model using operationally-focused business teams, typically located within 50 miles of our client companies. These teams are led by senior level business generalists and include senior level professionals with expertise in human resources, organizational development, risk mitigation and workplace safety, recruiting, employee benefits, and various types of administration, including payroll. These teams are responsible for growth and profitability of their operations, and for providing strategic leadership, guidance and expert consultation to our client companies. The decentralized structure fosters autonomous decision-making in which business teams deliver plans that closely align with the objectives of each business owner client. We support clients with a local presence in 68 markets throughout the United States.

Services Overview BBSI’s core purpose is to advocate for business owners, particularly in the small and mid-sized business segment. Our evolution from an entrepreneurially run company to a professionally managed organization has helped to form our view that all businesses experience inflection points at key stages of growth. The insights gained through our own growth, along with the trends we see in working with more than 7,770 companies each day, define our approach to guiding business owners through the challenges associated with being an employer. BBSI’s business teams align with each business owner client through a structured three-tiered progression. In doing so, business teams focus on the objectives of each business owner and deliver planning, guidance and resources in support of those objectives.

Tier 1: Tactical Alignment

The first stage focuses on the mutual setting of expectations and is essential to a successful client relationship. It begins with a process of assessment and discovery in which the business owner’s business objectives, attitudes, and culture are aligned with BBSI’s processes, controls and culture. This stage includes an implementation process, which addresses the administrative components of employment.

Tier 2: Dynamic Relationship

The second stage of the relationship emphasizes organizational development as a means of achieving each client’s business objectives. There is a focus on process improvement, development of best practices, supervisor training and leadership development.

Tier 3: Strategic Counsel

With an emphasis on advocacy on behalf of the business owner, the third stage of the relationship is more strategic and forward-looking with a goal of cultivating an environment in which all efforts are directed by the mission and long-term objectives of the business owner.

In addition to serving as a resource and guide, BBSI can provide workers’ compensation coverage as a means of meeting statutory requirements and protecting our clients from employment-related injury claims. Through our third-party administrators, we provide claims management services for our clients. We work to manage and reduce job injury claims, identify fraudulent claims and structure optimal work programs, including modified duty. In 2023, BBSI began offering employee benefits to our clients. The employee benefit programs are designed to provide strategic value to our clients through access to best-in-class plans and service. Benefit plans available to clients include medical, dental and vision plans, flexible spending accounts and health savings accounts, life insurance and voluntary accident coverage, and critical illness and disability coverage.

Results of Operations

The following table sets forth the percentages of total revenues represented by selected items in the Company’s condensed consolidated statements of operations for the three and nine months ended September 30, 2023 and 2022 ($ in thousands):

21

We report PEO revenues net of direct payroll costs because we are not the primary obligor for wage payments to our clients’ employees. However, management believes that gross billings and wages are useful in understanding the volume of our business activity and serve as an important performance metric in managing our operations, including the preparation of internal operating forecasts and establishing executive compensation performance goals. We therefore present for purposes of analysis gross billings and wage information for the three and nine months ended September 30, 2023 and 2022.

(Unaudited)

(Unaudited)

(in thousands)

In monitoring and evaluating the performance of our operations, management also reviews the following ratios, which represent selected amounts as a percentage of gross billings. Management believes these ratios are useful in understanding the efficiency and profitability of our service offerings.

(Unaudited)

(Unaudited)

The presentation of revenue on a net basis and the relative contributions of staffing and PEO services revenue can create volatility in our gross margin as a percentage of revenue. Generally, a relative increase in PEO services revenue will result in a higher gross margin as a percentage of revenue. Improvement in gross margin percentage occurs because incremental client services revenue dollars are reported as revenue net of all related direct payroll and safety incentive costs.

We refer to employees of our PEO clients as worksite employees (“WSEs”). Management reviews average and ending WSE growth to monitor and evaluate the performance of our operations. Average WSEs are calculated by dividing the number of unique individuals paid in each month by the number of months in the period. Ending WSEs represents the number of unique individuals paid in the last month of the period.

(Unaudited)

(Unaudited)

22

Three Months Ended September 30, 2023 and 2022

Net income for the third quarter of 2023 amounted to $18.2 million compared to net income of $17.4 million for the third quarter of 2022. Diluted net income per share for the third quarter of 2023 was $2.68 compared to diluted net income per share of $2.45 for the third quarter of 2022.

Revenue for the third quarter of 2023 totaled $273.3 million, a decrease of $0.5 million or 0.2% over the third quarter of 2022, which reflects an increase in the Company’s PEO services revenue of $6.9 million or 2.8% and a decrease in staffing services revenue of $7.4 million or 25.1%.

The increase in PEO services revenue was primarily attributable to an increase in the number of WSEs from net new clients, partially offset by a reduction in WSEs at existing clients, as well as an increase in average billing per WSE. The decrease in staffing services revenue was primarily due to lower demand for staffing services and continued tight labor market conditions in the third quarter of 2023.

Gross margin for the third quarter of 2023 totaled $68.3 million or 25.0% of revenue compared to $66.9 million or 24.4% of revenue for the third quarter of 2022. The separate components of gross margin are discussed below.

Direct payroll costs for the third quarter of 2023 totaled $16.3 million or 6.0% of revenue compared to $22.1 million or 8.1% of revenue for the third quarter of 2022. The decrease in direct payroll costs as a percentage of revenues was primarily due to a decrease in staffing services within the mix of our customer base compared to the third quarter of 2022.

Payroll taxes and benefits for the third quarter of 2023 totaled $135.7 million or 49.6% of revenue compared to $128.5 million or 46.9% of revenue for the third quarter of 2022. The increase in payroll taxes and benefits expense as a percentage of revenue was primarily due to PEO client benefit costs of $3.4 million in the third quarter of 2023 related to the availability of employee benefits to our PEO clients beginning in 2023.

Workers’ compensation expense for the third quarter of 2023 totaled $53.0 million or 19.4% of revenue compared to $56.4 million or 20.6% of revenue for the third quarter of 2022. The decrease in workers’ compensation expense as a percentage of revenue was primarily due to lower workers' compensation costs in the current year as well as favorable prior year liability and premium adjustments of $2.2 million in the third quarter of 2023, compared to favorable prior year liability adjustments of $1.4 million in the third quarter of 2022.

Selling, general and administrative (“SG&A”) expenses for the third quarter of 2023 totaled $44.2 million or 16.2% of revenue compared to $43.0 million or 15.7% of revenue for the third quarter of 2022. The increase as a percentage of revenue was primarily due to the decrease in staffing services within the mix of our customer base. The increase of $1.2 million in SG&A expense was primarily attributable to increased employee-related costs.

Other income, net for the third quarter of 2023 totaled $2.4 million compared to other income, net of $1.6 million for the third quarter of 2022. The increase was primarily attributable to an increase in investment income in the third quarter of 2023.

Our effective income tax rate for the third quarter of 2023 was 26.2% compared to 27.1% for the third quarter of 2022. Our income tax rate typically differs from the federal statutory tax rate of 21% primarily due to state taxes as well as federal and state tax credits.

Nine Months Ended September 30, 2023 and 2022

Net income for the first nine months of 2023 amounted to $36.1 million compared to net income of $35.7 million for the first nine months of 2022. Diluted net income per share for the first nine months of 2023 was $5.24 compared to diluted net income per share of $4.91 for the first nine months of 2022.

Revenue for the first nine months of 2023 totaled $792.6 million, an increase of $10.2 million or 1.3% over the first nine months of 2022, which reflects an increase in the Company's PEO services revenue of $33.8 million or 4.9% and a decrease in staffing services revenue of $23.6 million or 26.7%.

The increase in PEO services revenue was primarily attributable to an increase in the number of WSEs from net new clients, partially offset by a reduction in WSEs at existing clients, as well as an increase in average billing per WSE. The decrease in staffing services revenue was primarily due to lower demand for staffing services and continued tight labor market conditions in the first nine months of 2023.

Gross margin for the first nine months of 2023 totaled $176.9 million or 22.3% of revenue compared to $174.1 million or 22.3% of revenue for the first nine months of 2022. The separate components of gross margin are discussed below.

Direct payroll costs for the first nine months of 2023 totaled $48.3 million or 6.1% of revenue compared to $66.5 million or 8.5% of revenue for the first nine months of 2022. The decrease in direct payroll costs as a percentage of revenues was primarily due to a decrease in staffing services within the mix of our customer base compared to the first nine months of 2022.

Payroll taxes and benefits for the first nine months of 2023 totaled $414.4 million or 52.3% of revenue compared to $390.7 million or 49.9% of revenue for the first nine months of 2022. The increase in payroll taxes and benefits expense as a percentage of revenue was primarily due to PEO client benefit costs of $6.6 million related to the availability of employee benefits to our PEO clients beginning in 2023.

Workers' compensation expense for the first nine months of 2023 totaled $153.0 million or 19.3% of revenue compared to $151.1 million or 19.3% of revenue for the first nine months of 2022. Workers' compensation expense as a percentage of revenue benefited from lower workers' compensation costs in the current year, offset by lower favorable prior year liability and premium adjustments of $9.5 million in the first nine months of 2023 compared to favorable prior year liability and premium adjustments of $12.8 million in the first nine months of 2022.

SG&A expense for the first nine months of 2023 totaled $129.2 million or 16.3% of revenue compared to $125.4 million or 16.0% of revenue for the first nine months of 2022. The increase as a percentage of revenue was primarily due to the decrease in staffing services within the mix of our customer base. The increase of $3.8 million in SG&A expense was primarily attributable to increased employee-related costs.

Other income, net for the first nine months of 2023 totaled $6.8 million compared to other income, net of $4.8 million for the first nine months of 2022. The increase was primarily attributable to an increase in investment income in the first nine months of 2023.

Our effective income tax rate for the first nine months of 2023 was 26.8% compared to 26.9% for the first nine months of 2022. Our income tax rate typically differs from the federal statutory tax rate of 21% primarily due to state taxes as well as federal and state tax credits.

Fluctuations in Quarterly Operating Results

We have historically experienced significant fluctuations in our quarterly operating results, including losses or minimal income in the first quarter of each year, and expect such fluctuations to continue in the future. Our operating results may fluctuate due to a number of factors such as seasonality, wage limits on statutory payroll taxes, claims experience for workers’ compensation, demand for our services, and competition. Payroll taxes, as a component of cost of revenues, generally decline throughout a calendar year as the applicable statutory wage bases for federal and state unemployment taxes and Social Security taxes are exceeded on a per employee basis. Our revenue levels may be higher in the third quarter due to the effect of increased business activity of our customers’ businesses in the agriculture, food processing and forest products-related industries. In addition, revenues in the fourth quarter may be reduced by many customers’ practice of operating on holiday-shortened schedules. Workers’ compensation expense varies with both the frequency and severity of workplace injury claims reported during a quarter and the estimated future costs of such claims. In addition, positive or adverse loss development of prior period claims during a subsequent quarter may also contribute to the volatility in the Company’s estimated workers’ compensation expense.

Liquidity and Capital Resources

The Company’s cash balance of $62.4 million, which includes cash, cash equivalents, and restricted cash, decreased $44.9 million for the nine months ended September 30, 2023, compared to a decrease of $10.6 million for the comparable period of 2022. The decrease in cash at September 30, 2023 as compared to December 31, 2022 was primarily due to increased trade accounts receivable, decreased workers’ compensation claims liabilities, repurchases of common stock, and purchases of investments and restricted investments, partially offset by net income, increased accrued payroll, payroll taxes and related benefits, and increased premium payable.

Net cash provided by operating activities for the nine months ended September 30, 2023 amounted to $10.0 million, compared to cash used of $3.1 million for the comparable period of 2022. For the nine months ended September 30, 2023, net cash provided by operating activities was primarily due to net income of $36.1 million, increased accrued payroll, payroll taxes and related benefits of $25.8 million, and increased premium payable of $23.2 million, partially offset by increased trade accounts receivable of $41.4 million and decreased workers’ compensation claims liabilities of $38.7 million.

Net cash used in investing activities for the nine months ended September 30, 2023 totaled $17.5 million, compared to cash provided of $42.5 million for the comparable period of 2022. For the nine months ended September 30, 2023, net cash used in investing activities consisted of the purchase of investments and restricted investments of $25.3 million and the purchase of property, equipment and software of $8.1 million, partially offset by proceeds from sales and maturities of investments and restricted investments of $15.8 million.

Net cash used in financing activities for the nine months ended September 30, 2023 was $37.4 million, compared to cash used of $50.0 million for the comparable period of 2022. For the nine months ended September 30, 2023, net cash used in financing activities primarily consisted of repurchases of common stock of $29.1 million and dividend payments of $6.1 million.

The Company is required to maintain minimum collateral levels for certain policies issued under the insured program, which is held in a trust account (the “trust account”). The balance in the trust account was $178.7 million and $188.2 million at September 30, 2023 and December 31, 2022, respectively. The trust account balance is included as a component of the current and long-term restricted cash and investments in the Company’s condensed consolidated balance sheets.

See “Note 4 – Revolving Credit Facility and Long-Term Debt” to the unaudited condensed consolidated financial statements included in Item 1 of Part I of this report for additional information regarding the Company’s credit agreement with Wells Fargo Bank, N.A.

Forward-Looking Information

Statements in this report include forward-looking statements which are not historical in nature and are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. These forward-looking statements include, among others, discussion of economic conditions in our market areas and their effect on revenue levels, the lingering effects of the COVID-19 pandemic on our business operations, the competitiveness of our service offerings, the availability of certain fully insured medical and other health and welfare benefits to qualifying worksite employees, our ability to attract and retain clients and to achieve revenue growth, the effect of changes in our mix of services on gross margin, the effect of tight labor market conditions, the adequacy of our workers’ compensation reserves, the effect of changes in estimates of our future claims liabilities on our workers’ compensation reserves, including the effect of changes in our reserving practices and claims management process on our actuarial estimates, expected levels of required surety deposits and letters of credit, our ability to generate sufficient taxable income in the future to utilize our deferred tax assets, the effect of our formation and operation of two wholly owned licensed insurance subsidiaries, the risks of operation and cost of our insured program, the financial viability of our excess insurance carriers, the effectiveness of our management information systems, our relationship with our primary bank lender and the availability of financing and working capital to meet our funding requirements, litigation costs, the effect of changes in the interest rate environment on the value of our investment securities, the adequacy of our allowance for doubtful accounts, and the potential for and effect of acquisitions.

All our forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause the actual results, performance or achievements of the Company or industry to be materially different from any future results, performance or achievements expressed or implied by such forward-looking statements. Such factors with respect to the Company include: our ability to retain current clients and attract new clients; the effects of governmental orders, laws or regulations imposing requirements related to the COVID-19 pandemic; difficulties associated with integrating clients into our operations; economic trends in our service areas; the potential for material deviations from expected future workers’ compensation claims experience; changes in the workers’ compensation regulatory environment in our primary markets; security breaches or failures in the Company’s information technology systems; collectability of accounts receivable; changes in executive management; changes in effective payroll tax rates and federal and state income tax rates; the carrying values of deferred income tax assets and goodwill (which may be affected by our future operating results); the effects of inflation on our operating expenses and those of our clients; the impact of and potential changes to the Patient Protection and Affordable Care Act, escalating medical costs, and other health care legislative initiatives on our business; the effect of conditions in the global capital markets on our investment portfolio; and the availability of capital, borrowing capacity on our revolving credit facility, or letters of credit necessary to meet state-mandated surety deposit requirements for maintaining our status as a qualified self-insured employer for workers’ compensation coverage or our insured program. Additional risk factors affecting our business are discussed in Item 1A of Part I of our Annual Report on Form 10-K for the year ended December 31, 2022, which was filed with the SEC on March 6, 2023, and in Item 1A of Part II of this report. We disclaim any obligation to publicly announce any revisions to any of the forward-looking statements contained herein to reflect future events or developments.

The Company’s exposure to market risk for changes in interest rates primarily relates to its investment portfolio and its outstanding borrowings on its line of credit. As of September 30, 2023, the Company’s investments consisted principally of approximately $104.3 million in corporate bonds, $97.9 million in U.S. treasuries, $47.5 million in mortgage backed securities, $27.5 million in U.S. government agency securities, $14.1 million in asset backed securities, $7.9 million in mutual funds, $2.0 million in emerging markets securities and $1.7 million in money market funds. Based on the Company’s overall interest exposure at September 30, 2023, a 50 basis point increase in market interest rates would have a $5.2 million downward effect on the fair value of the Company’s investment portfolio. At September 30, 2023, the Company had no outstanding borrowings on its line of credit.

Evaluation of Disclosure Controls and Procedures

Management is responsible for establishing and maintaining adequate internal control over financial reporting (“ICFR”) as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act. Our ICFR is a process designed by, or under the supervision of, our Chief Executive Officer (“CEO”) and Chief Financial Officer (“CFO”), to provide reasonable assurance regarding the reliability of financial reporting and the preparation of our condensed consolidated financial statements for external purposes in accordance with GAAP.

We maintain “disclosure controls and procedures” that are designed with the objective of providing reasonable assurance that information required to be disclosed in the reports we file or submit under the Securities Exchange Act of 1934, as amended (the “Exchange Act”), is recorded, processed, summarized, and reported within the time periods specified in the SEC’s rules and forms, and that such information is accumulated and communicated to our management, including our CEO and CFO, as appropriate, to allow timely decisions regarding required disclosure. In designing and evaluating our disclosure controls and procedures, our management recognizes that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management is required to apply their judgment in evaluating the cost-benefit relationship of possible controls and procedures.

Based on their evaluation, the Company’s CEO and CFO have concluded that the Company’s disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) were effective as of September 30, 2023.

Changes in Internal Control over Financial Reporting

There have been no changes in the Company’s internal control over financial reporting that occurred during the quarter ended September 30, 2023 that have materially affected, or are reasonably likely to materially affect, the Company’s internal control over financial reporting.

Inherent Limitations

Control systems, no matter how well designed and operated, can provide only reasonable, not absolute, assurance that the control systems’ objectives are being met. Further, the design of any control systems must reflect the fact that there are resource constraints, and the benefits of all controls must be considered relative to their costs. Due to the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within the Company have been detected. These inherent limitations include the realities that judgments in decision making can be faulty and that breakdowns can occur because of simple errors or mistakes. Control systems can also be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the controls. The design of any system of controls is based in part on certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Over time, controls may become inadequate because of changes in conditions or deterioration in the degree of compliance with policies or procedures.

Other than the information below, there have been no material changes in the risk factors that were included in our Annual Report on Form 10-K for the year ended December 31, 2022, which was filed with the SEC on March 6, 2023.

If we are determined not to be an “employer” under certain laws and regulations, our clients may stop using our services, and we may be subject to additional liabilities.

We are the administrative employer in our co-employment relationships under the various laws and regulations of the IRS and the U.S. Department of Labor. If we are determined not to be the administrative employer under such laws and regulations and are therefore unable to assume our clients’ obligations for employment and other taxes, our clients may be held jointly and severally liable for payment of such taxes. Some clients or prospective clients may view such potential liability as an unacceptable risk, discouraging current clients from continuing a relationship with us or prospective clients from entering into a new relationship with us. Any determination that we are not the administrative employer for purposes of ERISA could also adversely affect our ability to offer health care benefits to our PEO clients by subjecting us to additional state and federal laws and regulations, and could materially adversely affect our business, financial condition, and results of operations.

Our business is subject to risks associated with healthcare reforms.

The Patient Protection and Affordable Care Act and the Health Care and Education Reconciliation Act of 2010 (collectively, the “Acts”) subject us to potential penalties unless we offer our employees minimum essential healthcare coverage that is affordable. To comply with the employer mandate provision of the Acts, we offer health care coverage to all temporary and permanent employees eligible for coverage under the Acts other than employees of our PEO clients, which are responsible for providing required health care coverage to their employees. Designating employees as eligible is complex and is subject to challenge by employees and the Internal Revenue Service (“IRS”). While we believe we have properly identified eligible employees, a later determination that we failed to offer the required health coverage to eligible employees could result in penalties that may materially harm our business.

Additionally, we began offering employee health and welfare benefits to our PEO clients beginning in 2023. We cannot be certain that compliant insurance coverage will remain available to us on reasonable terms, and we could face additional risks arising from future changes to or repeal of the Acts or changed interpretations of our obligations under the Acts. If new healthcare legislation or future changes to the Acts were to increase the cost of providing health care benefits, or to limit our ability to offer health care benefits to our PEO clients, our business, operating results, and financial condition could be materially adversely affected.

Failure to comply with applicable data security and privacy regulations related to our health care offering could adversely affect our business.

As BBSI began offering health benefits to our PEO clients in 2023, we have access to protected health information (PHI) of our client employees. Compliance with federal and state regulations such as HIPAA and the HITECH Act is required for handling this PHI. HIPAA imposes limitations on the use and disclosure of PHI, and sets requirements for health data privacy, security, and breach notification. Non-compliance with HIPAA can lead to penalties and fines. Failure to appropriately comply with data security regulations could materially adversely impact our business, reputation, operating results, and financial condition.