Royce Investment Partners Commentary: A Deep Dive Into 2 Quality Value Holdings
Barrett Business Services (Nasdaq: BBSI), which is in the Industrials sector, has completely changed its business model, and we are really seeing the benefits of that shift shine through. Barrett is a Professional Employer Organization, or PEO, that allows small businesses to essentially outsource Human Resources. While it has competitors, most focus primarily on white collar industries. Barrett, on the other hand, has always focused on what they call more gray collar industries, that is, a mix of white- and blue-collar industries. Its direct clients are small businesses, and the company serves approximately 125,000 employees across these businesses. These workers represent around $7.5 billion worth of wages and benefits, and BBSI receives a fee from each business based on a percentage of that total wage and benefits bill.
Barrett employs a high touch model that essentially combines PEO with a consultative approach. This combination leads to higher success rates for its clients, as well as lower churn rates for Barrettwhich has market leading customer retention rates in the 90% range. In addition, small businesses that hire a PEO will usually grow faster, have lower employee turnover, and be 50% less likely to go out of business. And Barretts high retention rates imply a highly recurring revenue business model. Barretts target market of businesses with fewer than 100 employees is only 15% penetrated, leaving ample room for future growth opportunities, while its referral network for new business leads to both lower customer acquisition costs and nearly pre-vetted candidates, resulting in high new business win rates. As a capital light business, Barrett can quickly and efficiently launch expansion opportunities while enjoying short earnback periods. This helps Barrett generate a lot of cash, with its most recent cash balance representing 20% of the companys total market capitalization.
Barretts current CEO, Gary Kramer, joined the company as CFO in 2016. After being promoted to CEO in early 2020, he instituted multiple changes that have drastically improved the firms business modelwhich we have gone largely unnoticed by the market. Historically, investors have shunned Barrett due to its gray collar end markets and the fact that it self-insured workers comp insurance offerings, creating higher risk. Under its new CEO, however, the company moved to an outsourced insurance model in which Barrett incurs no downside risk from policies, but still receives the upside benefits if claims come in lower than modeleda significant shift in the companys risk profile that we believe has not yet been recognized other investors.
Kramer has also implemented strategies and policies to better serve larger customers, increase Barretts marketing reach, and improve retention rates. All of which has led to a more robust growth model. Most important, the company began a beta trial of a health insurance offering for clients in 2023, with a system wide launch coming in 2024. This effort is also structured in the zero-downside risk model while also offering has two large benefits. First, it considerably expands the companys addressable market as potential clients who need a health insurance offering for their employees historically would not have been able to utilize Barretts services. Second, Barrett receives a fee for acting as the insurance broker, and this incremental revenue will drive significant earnings growth as there are few incremental operating costs to service this new revenue. We think that this new health insurance offering could increase earnings power by 25-50% over the long term, which is on top of an already attractive growth model.
One other highly attractive element to this opportunity is its potential for a very asymmetric return profile. Once adjusted for the significant cash balance, the stock trades at a price earnings ratio (PE) of only 10.0x FY2 EPS (earnings per share growth in the fiscal year after this one), which is both cheap on an absolute and relative basis. Barretts peers currently trade in the 16.0-25.0x P/E range. We therefore see limited downside risk. In fact, with earnings power set to potentially accelerate growth on the back of the health insurance launch, we think there is considerable upside potential both from growth in earnings and from multiple expansion.
We see Assured Guaranty (NYSE: AGO) as a great example of the diversity of our holdings in the Financials sector. It has a niche business insuring bonds, predominantly U.S. municipal debt instruments, and is known as a Financial Guaranty or FG, meaning that if a borrower (i.e., the municipality) misses an interest or principal payment, AGO pays it so the bondholders are unaffected. Bond insurance adds value for AGOs customers and, in our view, the bondholders as well. AGO is rated AA, but its capital levels are at AAA standards, and the company has an excellent reputation that comes with being the largest player in the industry. The industry has essentially been a duopoly since the Great Financial Crisis, which wiped out most other industry players. AGO now has a roughly 63% market share to go with the strongest balance sheet and best brand name. The municipalitiesAGOs direct customersbenefit from lower costs of capital and lower interest payments, which creates additional benefits, such as being better able to invest in their communities. Bondholders benefit from improved liquidity, the assurance of timely interest payments (thus reducing their risk), and professional underwriting, as each AGO insured bond is underwritten by the company.
We also especially like the companys admirable capital allocation record. Since 2013, AGO has retired 73% of its shares outstanding, or nearly $4.7 billion worth of stock, though it remains in a sizable excess capital position. AGO has also grown its book value per share (BVPS) at 14% a year for a decade. Even with its record of effective execution and position as the industry leader, we think its valuation is quite attractiveits shares have recently been trading at roughly 60% of BVPS. We see three significant implications of this attractively inexpensive valuation: it gives AGO a sizable margin of safety; the company looks less risky than it did a few years ago, as legacy risks from 2014s Puerto Rican bond crisis have largely been resolved. We expect to see meaningful share repurchases in in the second half of 2023 or early 2024.
Much of our thesis is rooted in the prospects of an industry rebound. Until recently, the bond insurance industry had been the victim of low interest rates, as lower rates meant less money for bond issuers, which made it less economical for AGO to write new policies. Lower rates also resulted in tighter spreads, which were similarly less economical for AGOs business. In addition, the low default environment engendered a reduced appetite for credit protection. The upshot was a more than 50% decline in the amount of debt that AGO insured over the last 14 years.
But this is all changing due to the current higher interest rate environment. In fact, the bond insurance industry appears poised for meaningful inflectionand AGO has been capitalizing on the recovery. Higher rates are driving increased demand for FG products, with 2Q23 being AGOs best quarter for new business in a decade. All of this could enable AGO to be a growing enterprise again, possibly resulting in significant multiple expansion over time. To be sure, we believe that the stock could double in the next 2-3 years. At roughly 60% of BVPS, and with the company likely to continue aggressively repurchasing shares over the next 6-9 months, we see limited downside as well.
Mr. Lewiss and Mr. Hintzs thoughts and opinions concerning the stock market are solely their own and, of course, there can be no assurance with regard to future market movements. No assurance can be given that the past performance trends as outlined above will continue in the future.
This article first appeared on GuruFocus.
