UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
For the Quarterly Period Ended September 30, 2016
For the Transition Period From to
Commission File Number 0-21886
BARRETT BUSINESS SERVICES, INC.
(Exact name of registrant as specified in its charter)
(State or other jurisdiction of
incorporation or organization)
(IRS Employer
Identification No.)
8100 NE Parkway Drive, Suite 200
Vancouver, Washington
(360) 828-0700
(Registrant’s telephone number, including area code)
Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ¨ No x
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes ¨ No x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of “large accelerated filer,” “accelerated filer”, and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act). Yes ¨ No x
As of November 1, 2016, 7,243,667 shares of the registrant’s common stock ($0.01 par value) were outstanding.
INDEX TO FORM 10-Q
Part I - Financial Information
Item 1.
Unaudited Interim Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets – September 30, 2016 and December 31, 2015
Condensed Consolidated Statements of Operations – Three Months Ended September 30, 2016 and 2015
Condensed Consolidated Statements of Operations – Nine Months Ended September 30, 2016 and 2015
Condensed Consolidated Statements of Comprehensive Income – Three Months and Nine Months Ended September 30, 2016 and 2015
Condensed Consolidated Statements of Stockholders’ Equity – Nine Months Ended September 30, 2016 and 2015
Condensed Consolidated Statements of Cash Flows – Nine Months Ended September 30, 2016 and 2015
Notes to Unaudited Condensed Consolidated Financial Statements
Item 2.
Management’s Discussion and Analysis of Financial Condition and Results of Operations
Item 3.
Quantitative and Qualitative Disclosures About Market Risk
Item 4.
Controls and Procedures
Part II - Other Information
Legal Proceedings
Item 1A.
Risk Factors
Unregistered Sales of Equity Securities and Use of Proceeds
Item 6.
Exhibits
Signature
Exhibit Index
2
PART I – FINANCIAL INFORMATION
Barrett Business Services, Inc.
Condensed Consolidated Balance Sheets
(Unaudited)
(In Thousands, Except Par Value)
Current assets:
Cash and cash equivalents
Trade accounts receivable, net
Income taxes receivable
Prepaid expenses and other
Investments
Restricted cash and investments
Deferred income taxes
Total current assets
Property, equipment and software, net
Goodwill
Other assets
Current liabilities:
Current portion of long-term debt
Accounts payable
Accrued payroll, payroll taxes and related benefits
Income taxes payable
Other accrued liabilities
Workers’ compensation claims liabilities
Safety incentives liability
Total current liabilities
Long-term workers’ compensation claims liabilities
Long-term debt
Customer deposits and other long-term liabilities
Total liabilities
Commitments and contingencies (Notes 4 and 6)
Stockholders’ equity:
Common stock, $.01 par value; 20,500 shares authorized, 7,244 and 7,203 shares issued and outstanding
Additional paid-in capital
Accumulated other comprehensive income (loss)
Retained earnings
The accompanying notes are an integral part of these condensed consolidated financial statements.
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Condensed Consolidated Statements of Operations
(In Thousands, Except Per Share Amounts)
Revenues:
Professional employer service fees
Staffing services
Total revenues
Cost of revenues:
Direct payroll costs
Payroll taxes and benefits
Workers’ compensation
Total cost of revenues
Gross margin
Selling, general and administrative expenses
Depreciation and amortization
Income from operations
Other income (expense):
Investment income
Interest expense
Loss on litigation
Other, net
Other expense, net
Income before income taxes
Provision for income taxes
Net income
Basic earnings per common share
Weighted average number of basic common shares outstanding
Diluted earnings per common share
Weighted average number of diluted common shares outstanding
Cash dividends per common share
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5
Condensed Consolidated Statements of Comprehensive Income
(In Thousands)
Unrealized gains on investments, net of tax of $2 and $4 in 2016 and 2015, respectively
Comprehensive income
Unrealized gains on investments, net of tax of $35 and $21 in 2016 and 2015, respectively
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Condensed Consolidated Statements of Stockholders’ Equity
Nine Months Ended September 30, 2016 and 2015
Balance, December 31, 2014 (As Restated)(1)
Common stock issued on exercise of options and vesting of restricted stock units
Common stock repurchased on vesting of restricted stock units
Share based compensation expense
Excess tax benefits from share-based compensation
Cash dividends on common stock
Unrealized gain on investments, net of tax
Net Income
Balance, September 30, 2015
Balance, December 31, 2015
Balance, September 30, 2016
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Condensed Consolidated Statements of Cash Flows
Cash flows from operating activities:
Reconciliations of net income to net cash provided by operating activities:
Losses (gains) recognized on investments
Losses recognized on sale of property and equipment
Share-based compensation
Excess tax benefit from share-based compensation
Changes in certain operating assets and liabilities:
Trade accounts receivable
Customer deposits, long-term liabilities and other assets, net
Net cash provided by operating activities
Cash flows used in investing activities:
Purchase of property and equipment
Proceeds from sale of property and equipment
Purchase of investments
Proceeds from sales and maturities of investments
Purchase of restricted cash and investments
Proceeds from sales and maturities of restricted cash and investments
Net cash used in investing activities
Cash flows used in financing activities:
Proceeds from credit-line borrowings
Payments on credit-line borrowings
Payments on long-term debt
Dividends paid
Proceeds from exercise of stock options and vesting of restricted stock units
Net cash used in financing activities
Net increase in cash and cash equivalents
Cash and cash equivalents, beginning of period
Cash and cash equivalents, end of period
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Notes to Condensed Consolidated Financial Statements (Unaudited)
Note 1 - Basis of Presentation of Interim Period Statements
The accompanying condensed consolidated financial statements are unaudited and have been prepared by Barrett Business Services, Inc. (“BBSI”, the “Company”, “our” or “we”), pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and note disclosures typically included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America (“GAAP”) have been condensed or omitted pursuant to such rules and regulations. In the opinion of management, the condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, necessary for a fair statement of the results for the interim periods presented. The preparation of consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results may differ from such estimates and assumptions. The condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and notes thereto included in the Company’s 2015 Annual Report on Form 10-K at pages F1 – F62. The results of operations for an interim period are not necessarily indicative of the results of operations for a full year.
Revenue recognition
We recognize professional employer (“PEO”) service and staffing service revenue as services are rendered by our workforce. PEO services are normally used by organizations to satisfy ongoing needs related to the management of human capital and are governed by the terms of a client services agreement which covers all employees at a particular work site. Our client services agreements have a minimum term of one year, are renewable on an annual basis and typically require 30 days’ written notice to cancel or terminate the contract by either party. In addition, our client services agreements provide for immediate termination upon any default of the client regardless of when notice is given.
We report PEO revenues on a net basis because we are not the primary obligor for the services provided by our clients to their customers pursuant to our client services agreements. We reduce these service fee revenues by the amounts invoiced to our clients for direct payroll expenses such as salaries, wages, health insurance, employee out-of-pocket expenses incurred incidental to employment, and safety incentives. Safety incentives represent cash incentives paid to certain client companies for maintaining safe-work practices and minimizing workplace injuries. The safety incentive is based on a percentage of annual payroll and is paid annually to clients who meet predetermined workers’ compensation claims cost objectives.
Cost of revenues
Our cost of revenues for staffing services includes direct payroll costs, employer payroll related taxes, employee benefits, and workers’ compensation costs. Our cost of revenues for PEO services includes only employer payroll related taxes and workers’ compensation costs. Direct payroll costs represent the gross payroll earned by staffing services employees based on salary or hourly wages. Payroll taxes and employee benefits consist of the employer’s portion of Social Security and Medicare taxes, federal and state unemployment taxes, and staffing services employee reimbursements for materials, supplies and other expenses, which are paid by our customer. Workers’ compensation costs consist primarily
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Note 1 - Basis of Presentation of Interim Period Statements (Continued)
of the costs associated with our workers’ compensation program, including claims reserves, claims administration fees, legal fees, medical cost containment (“MCC”) expense, state administrative agency fees, third-party broker commissions, risk manager payroll, and excess insurance premiums for catastrophic injuries. We maintain separate workers’ compensation insurance policies for employees working in states where the Company is not self-insured, including California.
We consider non-restricted short-term investments, which are highly liquid, readily convertible into cash, and have maturities at acquisition of less than three months to be cash equivalents for purposes of the condensed consolidated statements of cash flows and condensed consolidated balance sheets. The Company maintains cash balances in bank accounts that normally exceed FDIC insured limits. The Company has not experienced any losses related to its cash concentration.
As of September 30, 2016, the Company’s investments consisted of municipal bonds and corporate bonds. We classify our investments as trading or available-for-sale. The Company had no trading securities at September 30, 2016 and December 31, 2015. The Company classifies money market funds, municipal bonds, and corporate bonds as available for sale. They are reported at fair value with unrealized gains and losses, net of taxes, shown as a component of accumulated other comprehensive income (loss) in stockholders’ equity. Management considers available evidence in evaluating potential impairment of investments, including the duration and extent to which fair value is less than cost. Realized gains and losses on sales of investments are included in other income (expense) as other, net in our condensed consolidated statements of operations. In the event a loss is determined to be other-than-temporary, the loss will be recognized in the condensed consolidated statements of operations.
At September 30, 2016, restricted cash and investments consisted of money market funds, certificates of deposit, U.S. Treasuries, corporate bonds, and municipal bonds with maturities generally from 180 days to two years. At September 30, 2016, the approximate fair value of restricted cash and investments equaled their approximate amortized cost. Restricted investments have been categorized as available-for-sale. They are reported at fair value with unrealized gains and losses, net of taxes, shown as a component of accumulated other comprehensive income (loss) in stockholders’ equity. Management considers available evidence in evaluating potential impairment of investments, including the duration and extent to which fair value is less than cost. Realized gains and losses on sales of restricted investments are included in other income (expense) as other, net in our condensed consolidated statements of operations. In the event a loss is determined to be other-than-temporary, the loss will be recognized in the condensed consolidated statements of operations.
Allowance for doubtful accounts
The Company had an allowance for doubtful accounts of $195,000 and $268,000 at September 30, 2016 and December 31, 2015, respectively. We make estimates of the collectability of our accounts receivable for services provided to our customers. Management analyzes historical bad debts, customer concentrations, customer credit-worthiness, current economic trends and changes in customers’ payment trends when evaluating the adequacy of the allowance for doubtful accounts. If the financial condition of our customers deteriorates, resulting in an impairment of their ability to make payments, additional allowances may be required.
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Our workers’ compensation claims liabilities do not represent an exact calculation of liability but rather management’s best estimate, utilizing actuarial expertise and projection techniques, at a given reporting date. The estimated liability for open workers’ compensation claims is based on an evaluation of information provided by our internal claims adjusters and our third-party administrators for workers’ compensation claims, coupled with an actuarial estimate of future adverse cost development with respect to reported claims and incurred but not reported claims (together, “IBNR”). At September 30, 2016 and December 31, 2015, workers’ compensation claims liabilities included case reserve estimates for reported losses, plus additional amounts for estimated future adverse cost development of IBNR claims, MCC and legal costs, and unallocated loss adjustment expenses, including future administrative fees to be paid to third-party service providers. These estimates are reviewed at least quarterly and adjustments to estimated liabilities are reflected in current operating results as they become known.
The process of arriving at an estimate of unpaid claims and claims adjustment expense involves a high degree of judgment and is affected by both internal and external events, including changes in claims handling practices, changes in reserve estimation procedures, changes in individuals involved in the reserve estimation process, inflation, trends in the litigation and settlement of pending claims, and legislative changes.
Our estimates are based on informed judgment, derived from individual experience and expertise applied to multiple sets of data and analyses. We consider significant facts and circumstances known both at the time that loss reserves are initially established and as new facts and circumstances become known. Due to the inherent uncertainty underlying loss reserve estimates, the expenses incurred through final resolution of our liability for our workers’ compensation claims will likely vary from the related loss reserves at the reporting date. Therefore, as specific claims are paid out in the future, actual paid losses may be materially different from our current loss reserves.
The Company’s independent actuary provides management with an estimate of the current and long-term portions of our total workers’ compensation claims, which is an important factor in our process for estimating workers’ compensation claims liabilities. The current portion represents the independent actuary’s best estimate of payments the Company will make related to workers’ compensation claims over the ensuing twelve months. The Company will also pay out a portion of claims first incurred in the ensuing twelve months during that twelve-month period. The long-term portion represents the independent actuary’s best estimate of payments the Company will make related to workers’ compensation claims more than twelve months in the future.
A basic premise in most actuarial analyses is that historical data and past patterns demonstrated in the incurred and paid historical data form a reasonable basis upon which to project future outcomes, absent a material change. Significant structural changes to the available data can materially impact the reserve estimation process. To the extent a material change affecting the ultimate claim liability becomes known, such change is quantified to the extent possible through an analysis of internal Company data and, if available and when appropriate, external data. Nonetheless, actuaries exercise a considerable degree of judgment in the evaluation of these factors and the need for such actuarial judgment is more pronounced when faced with material uncertainties.
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Safety incentives represent cash incentives paid to certain PEO client companies for maintaining safe-work practices and minimizing workplace injuries. The incentive is based on a percentage of annual payroll and is paid annually to customers who meet predetermined workers’ compensation claims cost objectives. Safety incentive payments are made only after closure of all workers’ compensation claims incurred during the customer’s contract period. The safety incentive liability is estimated and accrued each month based upon contract year-to-date payroll and the then current amount of the customer’s estimated workers’ compensation claims reserves as established by us and our third-party administrator and the expected payout as determined by historical incentive payment trends. The Company provided $25.0 million and $21.3 million at September 30, 2016 and December 31, 2015, respectively, as an estimate of the liability for unpaid safety incentives. Safety incentive costs are netted against PEO service revenue in our condensed consolidated statements of operations.
Statements of cash flows
Interest paid during the nine months ended September 30, 2016 and 2015 did not materially differ from interest expense. Income taxes received during the nine months ended September 30, 2016 and 2015 totaled $1.1 million and $9.2 million, respectively.
Basic and diluted earnings per share
Basic earnings per share are computed based on the weighted average number of common shares outstanding for each year using the treasury method. Diluted earnings per share reflect the potential effects of the exercise of stock options and the payment of stock awards from other share-based compensation plans that are outstanding at the end of each period presented. Basic and diluted shares outstanding are summarized as follows (in thousands):
Weighted average number of basic shares outstanding
Effect of dilutive securities
Weighted average number of diluted shares outstanding
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Accounting estimates
The preparation of our condensed consolidated financial statements in conformity with GAAP requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting periods. Management bases its estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Estimates are used for fair value measurement of all investments, allowance for doubtful accounts, deferred income taxes, carrying values for goodwill and property and equipment, accrued workers’ compensation liabilities and safety incentive liabilities. Actual results may differ from such estimates.
Recent accounting pronouncements
In May 2014, the Financial Accounting Standards Board (“FASB”) issued Accounting Standards Update No. 2014-09, Revenue from Contracts with Customers (“ASU 2014-09”). The amendments in ASU 2014-09 provide for a single, principles-based model for revenue recognition that replaces the existing revenue recognition guidance. In August 2015, the FASB issued ASU 2015-14 which defers the effective date of ASU 2014-09 by one year. ASU 2014-09 is discussed in the Company’s Annual Report on Form 10-K for the year ended December 31, 2015. In March and April 2016, the FASB issued ASU 2016-08 Principal versus Agent Considerations (Reporting Revenue Gross versus Net), ASU 2016-10 Identifying Performance Obligations and Licensing, ASU 2016-11 Revenue Recognition and Derivatives and Hedging: Rescission of SEC Guidance Because of Accounting Standards Updates 2014-09 and 2014-16 Pursuant to Staff Announcements at the March 3, 2016 EITF Meeting, and ASU 2016-12 Revenue from Contracts with Customers: Narrow-Scope Improvements and Practical Expedients, which all provide further clarification to be considered when implementing ASU 2014-09. The new guidance is effective for interim and annual reporting periods beginning after December 15, 2017. Early adoption is permitted as of the date of the original effective date, for interim and annual reporting periods beginning after December 15, 2016. The Company plans to adopt this ASU on January 1, 2018 and is in the process of evaluating its planned transition method and the impact to its consolidated financial statements and disclosures of the adoption of ASU 2014-09.
In April 2015, the FASB issued Accounting Standards Update No. 2015-03, Interest—Imputation of Interest (“ASU 2015-03”) to simplify the presentation of debt issuance costs. ASU 2015-03 requires debt issuance costs be presented on the balance sheet as a direct reduction from the carrying amount of the related debt liability. The amendments in this accounting standard update are to be applied retrospectively and are effective for interim and annual reporting periods beginning after December 15, 2015. We do not expect the adoption of this accounting standard update to have a material impact on our consolidated financial statements and disclosures.
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In May 2015, the FASB issued ASU 2015-07, Disclosures for Investments in Certain Entities That Calculate Net Asset Value per Share (or Its Equivalent) (“ASU 2015-07”). ASU 2015-07 provides that investments for which the practical expedient is used to measure fair value at net asset value per share (“NAV”) must be removed from the fair value hierarchy. Instead, those investments must be included as a reconciling line item so that the total fair value amount of investments in the disclosure is consistent with the amount on the balance sheet. ASU 2015-07 also includes disclosure requirements for investments for which the NAV practical expedient was used to determine fair value. The adoption of this guidance in the third quarter of 2016 did not impact our financial condition or results of operations.
In November 2015, the FASB issued Accounting Standards Update No. 2015-17, Balance Sheet Classification of Deferred Taxes (“ASU 2015-17”). ASU 2015-17 requires that all deferred tax assets and liabilities, along with any related valuation allowance, be classified as noncurrent on the balance sheet. The guidance becomes effective for the Company beginning with our annual report for the year ending December 31, 2017 with early adoption permitted. The adoption of this standard is not expected to have a material impact on the Company’s consolidated financial statements and disclosures.
In February 2016, the FASB issued ASU 2016-02, Leases (“ASU 2016-02”). ASU 2016-02 requires a lessee to record a right of use asset and a corresponding lease liability on the balance sheet for all leases with terms longer than 12 months. ASU 2016-02 is effective for all interim and annual reporting periods beginning after December 15, 2018. Early adoption is permitted. A modified retrospective transition approach is required for lessees for capital and operating leases existing at, or entered into after, the beginning of the earliest comparative period presented in the financial statements, with certain practical expedients available. The Company is in the process of evaluating the impact of ASU 2016-02 on the Company’s consolidated financial statements and disclosures.
In March 2016, the FASB issued ASU 2016-09, Compensation—Stock Compensation (“ASU 2016-09”). ASU 2016-09 simplifies the accounting for the taxes related to stock-based compensation, including adjustments to how excess tax benefits and a company’s payments for tax withholdings should be classified. This guidance will be effective for fiscal years beginning after December 15, 2016. The Company is currently evaluating the impact that ASU 2016-09 will have on its consolidated financial statements and disclosures.
In August 2016, the FASB issued ASU No. 2016-15, “Statement of Cash Flows: Classification of Certain Cash Receipts and Cash Payments.” ASU No. 2016-15 clarifies and provides specific guidance on eight cash flow classification issues that are not currently addressed by current GAAP, thereby reducing the current diversity in practice. ASU No. 2016-15 is effective for public business entities for annual periods, including interim periods within those annual periods, beginning after December 15, 2017, with early application permitted. This guidance is applicable to the Company’s fiscal year beginning January 1, 2018. The Company is in the process of evaluating the impact of adoption of ASU 2016-15 to the presentation of consolidated cash flows.
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Note 2 - Fair Value Measurement
The following table summarizes the Company’s investments at September 30, 2016 and December 31, 2015 (in thousands):
Current:
Cash Equivalents:
Money Market Funds
Investments:
Municipal Bonds
Corporate Bonds
Restricted cash and investments:
Certificate of Deposit
Total Current Investments
Long term:
Restricted cash and investments(1):
Certificates of Deposit
U.S. Treasuries
Total Long Term Investments
Total Investments
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Note 2 - Fair Value Measurement (Continued)
The following table summarizes the Company’s investments at September 30, 2016 and December 31, 2015 measured at fair value on a recurring basis by fair value hierarchy level (in thousands):
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Note 3 - Workers’ Compensation Claims
The following table summarizes the aggregate workers’ compensation reserve activity (in thousands):
Beginning balance
Add: claims expense accrual:
Current period
Prior periods
Less: claim payments related to:
Ending balance
Incurred but not reported (IBNR)
The states of California, Maryland, Oregon, Washington, Colorado and Delaware required us to maintain specified investment balances or other financial instruments totaling $159.0 million at September 30, 2016 to cover potential workers’ compensation claims losses related to the Company’s current and former status as a self-insured employer. In addition to restricted cash and investments held to satisfy these requirements at September 30, 2016, we have provided surety bonds and standby letters of credit totaling $152.9 million, including a California requirement of $147.2 million.
The Company also operates a wholly owned insurance company, Ecole Insurance Company (“Ecole”). Ecole is a fully licensed insurance company holding a certificate of authority from the Arizona Department of Insurance. Ecole provides workers’ compensation coverage to the Company’s employees working in Arizona, Utah and Nevada. The surplus of Ecole was $10.8 million and $9.5 million at September 30, 2016 and December 31, 2015, respectively, and is included in long-term restricted cash and investments in our condensed consolidated balance sheets.
As part of its fronted workers’ compensation insurance program with Chubb Limited (“Chubb”, formerly ACE Group) in the states of California, Delaware, Virginia, Pennsylvania, North Carolina, New Jersey, West Virginia and the District of Columbia, the Company makes payments into a trust account (“the Chubb trust account”) to be used for the payment of future claims. The balance in the Chubb trust account was $235.2 million and $166.6 million at September 30, 2016 and December 31, 2015, respectively. The Chubb trust account balances are included as a component of the current and long-term restricted cash and investments in the Company’s condensed consolidated balance sheets.
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Note 3 - Workers’ Compensation Claims (Continued)
At September 30, 2016 the Company recorded an asset of $13.2 million related to a payment remitted to Chubb on September 29, 2016 but not deposited into the Chubb trust account until October 2016. This amount is included in other assets in the condensed consolidated balance sheet.
Note 4 - Revolving Credit Facility and Long-Term Debt
The Company maintains a credit agreement (the “Agreement”) with its principal bank, Wells Fargo Bank, National Association (the “Bank”). The Agreement provided for a $40.0 million term loan maturing December 31, 2016, as well as a $14.0 million revolving credit line, with a $6.0 million sublimit for unsecured standby letters of credit. As of September 30, 2016, the term loan has been paid off completely, compared to an outstanding balance of $15.0 million at December 31, 2015.
The Agreement also included $42.3 million in cash-secured letters of credit at September 30, 2016 to satisfy collateral requirements associated with the Company’s former status as a self-insured employer in California. In conjunction with these letters of credit, the Company posted with the Bank as collateral $44.1 million in restricted money market funds and restricted certificates of deposit.
Advances under the revolving credit facility bear interest as selected by the Company of either (a) a daily floating rate of one month LIBOR plus 2.0% or (b) a fixed rate of LIBOR plus 2.0%. The Agreement also provides for an unused commitment fee of 0.35% per year on the average daily unused amount of the revolving credit facility, and a fee of 1.75% of the face amount of each letter of credit. The Company had no outstanding borrowings on its revolving credit line at September 30, 2016 and December 31, 2015. The revolving credit line expires on October 1, 2017.
The credit facility is collateralized by the Company’s accounts receivable and other rights to receive payment, general intangibles and equipment.
The Agreement requires the satisfaction of certain financial covenants as follows:
The Agreement includes certain additional restrictions as follows:
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Note 4 - Revolving Credit Facility and Long-Term Debt (Continued)
The Agreement also contains customary events of default. If an event of default under the Agreement occurs and is continuing, the Bank may declare any outstanding obligations under the Agreement to be immediately due and payable.
At September 30, 2016, the Company was in violation of the capital expenditure restriction. The Bank agreed to waive this covenant violation.
The Company maintains a mortgage loan with the Bank with a balance of approximately $4.7 million and $4.8 million at September 30, 2016 and December 31, 2015, respectively, secured by the Company’s corporate office building in Vancouver, Washington. This loan requires payment of monthly principal payments of $18,375 plus interest at a rate of one month LIBOR plus 2.25%, with the unpaid principal balance due November 1, 2017.
Note 5 - Income Taxes
Under ASC 740, “Income Taxes,” management evaluates the realizability of the deferred tax assets on a quarterly basis under a “more-likely than not” standard. As part of this evaluation, management reviews all evidence both positive and negative to determine if a valuation allowance is needed. One component of this analysis is to determine whether the Company was in a cumulative loss position for the most recent 12 quarters. The Company was in a cumulative income position for the 12 quarters ended September 30, 2016. Based on management’s analysis, no valuation allowance of deferred tax assets was recorded at September 30, 2016.
The Internal Revenue Service is examining the Company’s federal tax returns for the years ended December 31, 2011, 2012, 2013 and 2014.
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Note 6 - Litigation
On November 6, 2014, plaintiffs in Michael Arciaga, et al. v. Barrett Business Services, Inc., et al., filed an action in the United States District Court for the Western District of Washington against BBSI, Michael L. Elich, BBSI’s Chief Executive Officer, and James D. Miller, BBSI’s then Chief Financial Officer. The action purported to be a class action brought on behalf of all BBSI shareholders alleging violations of the federal securities laws. The claims arose from the decline in the market price for BBSI common stock following announcement of a charge for increased workers’ compensation reserves expense. The lawsuit sought compensatory damages, plus interest, and costs and expenses (including attorney fees and expert fees).
On November 13, 2014, a second purported shareholder class action was filed in the United States District Court for the Western District of Washington, entitled Christopher P. Carnes, et al. v. Barrett Business Services, Inc., et al. The Carnes complaint named the same defendants as the Arciaga case and asserted similar claims for relief.
Similarly, on November 17, 2014, a third purported shareholder class action was filed in the United States District Court for the Western District of Washington, entitled Shiva Stein, et al. v. Barrett Business Services, Inc., et al. The Stein complaint named the same defendants as the Arciaga and Carnes cases and asserted similar claims for relief.
On February 25, 2015, the court ordered consolidation of the three cases, and any new or other cases involving the same subject matter, into a single action for pretrial purposes. The consolidated cases were recaptioned as In re Barrett Business Services Securities Litigation. The court also appointed the Painters & Allied Trades District Council No. 35 Pension and Annuity Funds as the lead plaintiff.
On March 21, 2016, before the court had ruled on the defendants’ motion to dismiss the plaintiffs’ first amended consolidated complaint, the plaintiffs filed a second amended consolidated complaint, naming the same defendants. The second amended consolidated complaint dropped certain allegations from the first amended complaint and added new allegations relating to disclosures in BBSI’s Current Report on Form 8-K filed on March 9, 2016. The defendants filed a motion to dismiss the second amended consolidated complaint on May 23, 2016.
On October 26, 2016, before the court ruled on the motion to dismiss, the parties entered into a Stipulation and Agreement of Settlement dated as of October 26, 2016 (the “Settlement”), to settle the litigation. The settlement class includes all persons and entities who purchased or otherwise acquired BBSI common stock in the period beginning February 12, 2013, through March 9, 2016, and were damaged thereby, with certain exclusions.
The Settlement is intended to fully, finally and forever compromise, settle, release, resolve, and dismiss with prejudice the purported class action and all claims asserted therein against the named defendants. In the Settlement, the defendants have denied all allegations of wrongdoing and the plaintiffs have not conceded any infirmities in their positions.
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Note 6 – Litigation (Continued)
The Settlement calls for the payment in cash of $12.0 million (the “Settlement Fund”) into escrow by November 29, 2016, which is 15 business days after the court entered an order preliminarily approving the Settlement. Of this amount, approximately $8.7 million will be paid by BBSI’s insurance carriers and approximately $3.3 million will be paid by BBSI. The amount to be paid by BBSI has been accrued at September 30, 2016 and is included in other accrued liabilities in our condensed consolidated balance sheet. The fees of counsel for the plaintiffs will be paid out of the Settlement Fund following approval by the court.
The Settlement is subject to approval by the court and to other customary terms and conditions, including the right of BBSI to terminate the Settlement under specified circumstances. All potential class members will be notified of the Settlement in November 2016. The court has scheduled a hearing for February 22, 2017, to consider final approval of the Settlement. If the Settlement is not approved by the court, or is otherwise terminated before it is finalized, BBSI is unable to predict the final outcome of the litigation or to estimate its effect on BBSI, which may be material and adverse.
BBSI received a subpoena from the San Francisco office of the Division of Enforcement of the Securities and Exchange Commission (the “SEC”) in May 2015 in connection with the SEC’s investigation of BBSI’s accounting practices with regard to its workers’ compensation reserves. In April 2016, the SEC issued a second subpoena to BBSI for documents relating to the disclosures made by BBSI following Mr. Miller’s termination. BBSI was also advised by the United States Department of Justice in mid-June 2016 that it has commenced an investigation. BBSI is cooperating fully with the investigations.
On June 17, 2015, Daniel Salinas (“Salinas”) filed a shareholder derivative lawsuit against BBSI and certain of its officers and directors in the Circuit Court for Baltimore City, Maryland. The complaint alleges breaches of fiduciary duty, unjust enrichment and other violations of law and seeks recovery of various damages, including the costs and expenses incurred in connection with BBSI’s reserve strengthening process, reserve study and consultants, the cost of stock repurchases by BBSI in October 2014, compensation paid to BBSI’s officers, and costs of negotiating BBSI’s credit facility with its principal lender, as well as the proceeds of sales of stock by certain of BBSI’s officers and directors during 2013 and 2014. On September 28, 2015, BBSI and the individual defendants filed motions to dismiss the derivative suit and a motion to stay pending resolution of In re Barrett Business Services Securities Litigation. On December 4, 2015, Salinas filed an opposition to each motion. On January 27, 2016, the defendants filed a reply to the opposition brief. On February 11, 2016, Judge Michel Pierson heard oral argument on the motions. A decision has not been issued.
Management is unable to estimate the probability, or the potential range of loss arising from the legal actions described above.
BBSI is subject to other legal proceedings and claims, which arise in the ordinary course of our business. In the opinion of management, the amount of ultimate liability with respect to other currently pending or threatened actions is not expected to materially affect BBSI’s consolidated financial position or results of operations.
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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:
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 comprise senior level professionals with expertise in human resources, organizational development, risk mitigation and workplace safety and various types of administration, including payroll. These teams are responsible for growth 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. This structure also provides a means of incubating talent to support increased growth and capacity. We support clients with employees located in 22 states and the District of Columbia through a network of 55 branch locations in California, Oregon, Washington, Arizona, Colorado, Idaho, Nevada, Utah, Delaware, Maryland, North Carolina and Virginia. We also have several smaller recruiting locations in our general market areas, which are under the direction of a branch office.
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BBSI believes that making significant investments in the best talent available allows us to leverage the value of this investment many times over. We motivate our management employees through a compensation package that includes a competitive base salary and the opportunity for profit sharing. At the branch level, profit sharing is in direct correlation to client performance, reinforcing a culture focused on achievement of client goals.
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 inform 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 4,100 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 has the ability to provide workers’ compensation coverage as a means of meeting statutory requirements and protecting our clients from employment-related injury claims. Through our internal claims managers and our third-party administrators, we provide claims management services for our clients. We work aggressively to manage and reduce job injury claims, identify fraudulent claims and structure optimal work programs, including modified duty.
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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, 2016 and 2015.
Other income (expense), net
We report professional employer service revenues on a net basis because we are not the primary obligor for the services provided by our co-employed clients to their customers pursuant to our client service agreements. We present for comparison purposes the gross revenues and cost of revenues information for the three and nine months ended September 30, 2016 and 2015 in the table below. Although not in accordance with GAAP, management believes this information is informative as to the level of our business activity and illustrative of how we manage our operations, including the preparation of our internal operating forecasts, because it presents our professional employer services on a basis comparable to our staffing services.
The presentation of revenues on a net basis and the relative contributions of staffing and professional employer services revenues can create volatility in our gross margin percentage. The general impact of fluctuations in our revenue mix is described below.
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Non-GAAP (in thousands)
Gross revenues:
Professional employer services
Total gross revenues
Gross cost of revenues:
Total gross cost of revenues
A reconciliation of net revenue to non-GAAP gross revenues is as follows for the three and nine months ended September 30, 2016 and 2015 (in thousands):
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The non-GAAP adjustments comprise direct payroll costs and safety incentives attributable to our professional employer services client companies.
Three months ended September 30, 2016 and 2015
Net income for the third quarter of 2016 amounted to $10.2 million compared to net income of $11.0 million for the third quarter of 2015. Diluted income per share for the third quarter of 2016 was $1.38 compared to diluted income per share of $1.49 for 2015.
Revenues for the third quarter of 2016 totaled $225.1 million, an increase of approximately $26.4 million or 13.3% over the third quarter of 2015, which reflects an increase in the Company’s professional employer service fee revenue of $25.1 million or 16.5%, and an increase in staffing services revenue of $1.3 million or 2.7%.
Approximately 78% and 77%, respectively, of our total net revenues during the third quarter of 2016 and 2015 was attributable to our California operations.
Our growth in professional employer service revenues was attributable to both new and existing customers. Due to continued strength in our referral channels, business from new customers during the third quarter of 2016 nearly doubled business lost from former customers. Professional employer service revenue from continuing customers reflected a 9.1% increase compared to the third quarter of 2015, primarily resulting from increases in employee headcount and hours worked. The increase in staffing services revenue was due primarily to an increase in new staffing business.
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Three months ended September 30, 2016 and 2015 (Continued)
Gross margin for the third quarter of 2016 totaled approximately $49.6 million or 22.0% of revenue compared to $42.9 million or 21.6% of revenue for the third quarter of 2015. The increase in gross margin percentage was primarily due to a decrease in direct payroll costs along with payroll taxes and benefits, as a percentage of revenues, partially offset by an increase in workers’ compensation expense, as a percentage of revenues.
Direct payroll costs for the third quarter of 2016 totaled approximately $37.0 million or 16.4% of revenue compared to $35.3 million or 17.8% of revenue for the third quarter of 2015. The decrease in direct payroll costs percentage was primarily due to the increase in professional employer services and the decrease of staffing services within the mix of our customer base compared to the third quarter of 2015.
Payroll taxes and benefits for the third quarter of 2016 totaled approximately $82.9 million or 36.8% of revenue compared to $75.2 million or 37.8% of revenue for the third quarter of 2015. The decrease in payroll taxes and benefits percentage was due to a $3.8 million federal unemployment tax credit recognized in the third quarter of 2016. This included $2.9 million for tax years 2013, 2014 and 2015. Adjusting for this credit, payroll taxes and benefits as a percentage of revenues was 38.5% in the third quarter of 2016. This increase is in line with the growth in professional employer services where payroll taxes and benefits are presented at gross cost.
Workers’ compensation expense for the third quarter of 2016 totaled approximately $55.6 million or 24.7% of revenue compared to $45.3 million or 22.8% of revenue for the third quarter of 2015. The increase in workers’ compensation expense percentage was primarily due to an increase in current period claims expense from $29.7 million in the third quarter of 2015 to $38.1 million in the third quarter of 2016, coupled with a reduction in prior periods claims expense of $2.4 million in the third quarter of 2015 compared to a reduction of $1.0 million in the third quarter of 2016.
Selling, general and administrative (“SG&A”) expenses for the third quarter of 2016 totaled approximately $30.4 million or 13.5% of revenue compared to $25.4 million or 12.8% of revenue for the third quarter of 2015. The increase as a percentage of revenue was primarily due to $1.7 million in legal and accounting costs associated with financial restatements, outside investigations and legal proceedings related to securities law issues.
Other expense, net for the third quarter of 2016 totaled approximately $3.3 million as compared to an expense of $216,000 for the third quarter of 2015. The change was attributable to a $3.3 million litigation settlement.
Our effective income tax rate for the third quarter of 2016 was 31.9%, compared to 33.5% for the third quarter of 2015. Our income tax rate typically differs from the federal statutory tax rate of 35% primarily due to federal and state tax credits.
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Nine months ended September 30, 2016 and 2015
Net income for the nine months ended September 30, 2016 amounted to $10.8 million compared to a net income of $14.0 million for the first nine months of 2015. Diluted income per share for the first nine months of 2016 was $1.46 compared to diluted income per share of $1.91 for 2015.
Revenues for the first nine months of 2016 totaled $619.5 million, an increase of approximately $72.4 million or 13.2% over the similar period of 2015, which reflects an increase in the Company’s professional employer service fee revenue of $78.7 million or 18.8%, offset by a decrease in staffing services revenue of $6.3 million or 4.9%.
Approximately 78% of our total net revenues during the first nine months ended September 30, 2016 and 2015 was attributable to our California operations.
Our growth in professional employer service revenues was attributable to both new and existing customers. Due to continued strength in our referral channels, business from new customers during the first nine months of 2016 nearly doubled business lost from former customers. Professional employer service revenue from continuing customers reflected an 8.1% increase compared to the first nine months of 2015, primarily resulting from increases in employee headcount and hours worked. The decrease in staffing services revenue was due primarily to a decrease in net staffing business as lost business from former customers exceeded the addition of new business, coupled with a decrease in revenue from continuing customers.
Gross margin for the first nine months of 2016 totaled approximately $102.2 million or 16.5% of revenue compared to $88.3 million or 16.1% of revenue for the first nine months of 2015. The increase in gross margin percentage was primarily due to a decrease in direct payroll costs as a percentage of revenues, partially offset by increases in workers’ compensation expense and payroll taxes and benefits as a percentage of revenues.
Direct payroll costs for the first nine months of 2016 totaled approximately $92.7 million or 15.0% of revenue compared to $97.3 million or 17.8% of revenue for the first nine months of 2015. The decrease in direct payroll costs percentage was primarily due to the increase in professional employer services and the decrease of staffing services within the mix of our customer base compared to the first nine months of 2015.
Payroll taxes and benefits for the first nine months of 2016 totaled approximately $269.5 million or 43.5% of revenue compared to $235.1 million or 43.0% of revenue for the first nine months of 2015. The increase in payroll taxes and benefits percentage was primarily due to the effect of growth in professional employer services, where payroll taxes and benefits are presented at gross cost. The effect of the growth in professional employer services on payroll taxes and benefits was partially offset by a $3.8 million federal unemployment tax credit recognized in the third quarter of 2016.
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Nine months ended September 30, 2016 and 2015 (Continued)
Workers’ compensation expense for the first nine months of 2016 totaled approximately $155.1 million or 25.0% of revenue compared to $126.4 million or 23.1% of revenue for the first nine months of 2015. The increase in workers’ compensation expense percentage was primarily due to the reduction in prior periods’ claims expense of $9.7 million in the first nine months of 2015 compared to a reduction of $1.5 million in the first nine months of 2016, coupled with an increase in current period claims expense from $84.9 million in the first nine months of 2015 to $103.9 million in the first nine months of 2016.
SG&A expenses for the first nine months of 2016 totaled $80.8 million, or 13.0% of revenue compared to $63.8 million or 11.7% of revenue for the first nine months of 2015. A portion of the increase was due to $6.1 million in legal and accounting costs associated with financial restatements, outside investigations and legal proceedings related to securities law issues.
Other expense, net for the nine months ended September 30, 2016 totaled approximately $3.3 million as compared to $1.1 million for the first nine months of 2015. The change was attributable to a $3.3 million litigation settlement recognized in the third quarter of 2016, partially offset by a decline in interest expense and an increase in investment income.
Our effective income tax rate for the first nine months of 2016 was 31.7%, compared to 34.0% for the first nine months of 2015. Our income tax rate typically differs from the federal statutory tax rate of 35% primarily due to federal and state tax credits.
Fluctuations in Quarterly Operating Results
We have historically experienced significant fluctuations in our quarterly operating results, including losses 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, 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.
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Liquidity and Capital Resources
The Company’s cash position of $26.8 million at September 30, 2016 increased $1.6 million from December 31, 2015, compared to an increase of $5.3 million for the comparable period of 2015. The increase in cash at September 30, 2016, as compared to December 31, 2015, was primarily due to net income of $10.8 million, proceeds from securities of $95.6 million, an increase in accrued payroll, payroll taxes and related benefits of $39.7 million and an increase in workers’ compensation claims liabilities of $36.3 million, partially offset by purchases of securities of $127.5 million and an increase in trade accounts receivable of $49.5 million.
Net cash provided by operating activities for the nine months ended September 30, 2016 amounted to $57.3 million, compared to cash provided by operating activities of $51.3 million for the comparable period of 2015. For the nine months ended September 30, 2016, cash flow was primarily due to net income of $10.8 million, an increase in accrued payroll, payroll taxes and related benefits of $39.7 million and an increase in workers’ compensation claims liabilities of $36.3 million, partially offset by an increase in trade accounts receivable of $49.5 million.
Net cash used in investing activities totaled $35.7 million for the nine months ended September 30, 2016, compared to net cash used of $31.3 million for the comparable period of 2015. For the nine months ended September 30, 2016, cash used in investing activities consisted primarily of purchases of restricted cash and investments of $127.2 million, partially offset by proceeds from sales and maturities of restricted cash and investments of $91.1 million.
Net cash used in financing activities for the nine months ended September 30, 2016 was $20.0 million, compared to net cash used in financing activities of $14.6 million for the comparable period of 2015. For the nine months ended September 30, 2016, cash was primarily used for debt payments of $15.2 million and dividend payments of $4.8 million.
Due to a decrease in our California workers’ compensation claims liability during the first nine months of 2016, the surety insurers decreased their letter of credit requirement to $42.3 million at September 30, 2016 from $88.3 million at December 31, 2015. The collateral associated with the letters of credit decreased to $44.1 million at September 30, 2016 from $92.4 million at December 31, 2015.
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Management expects the letters of credit and related collateral to decrease over time as a result of a declining self-insured liability in California. The Company’s self-insured status in California ended on December 31, 2014.
Ecole, our wholly owned insurance company, provides workers’ compensation coverage to the Company’s employees working in Arizona, Utah and Nevada. The surplus of Ecole was $10.8 million and $9.5 million at September 30, 2016 and December 31, 2015, respectively, and is included in long-term restricted cash and investments in our condensed consolidated balance sheets.
As part of the Chubb fronted workers’ compensation insurance program, the Company makes monthly payments into the Chubb trust account, to be used for the payment of future claims. The balance in the Chubb trust account was $235.2 million and $166.6 million at September 30, 2016 and December 31, 2015, respectively. The Chubb trust account balance is made up of money market funds, included as a component of the current and long-term restricted cash and investments in the Company’s consolidated balance sheets.
At September 30, 2016 the Company recorded an asset of $13.2 million related to a payment remitted to Chubb on September 29, 2016 but not deposited into the Chubb trust account until October 2016. This amount is included in other assets in the condensed consolidated balance sheet and is included in cash used in investing activities in the condensed consolidated statement of cash flows.
Advances under the revolving credit facility bear interest as selected by the Company of either (a) a daily floating rate of one month LIBOR plus 2.0% or (b) a fixed rate of LIBOR plus 2.0%. The Agreement also provides for an unused commitment fee of 0.35% per year on the average daily unused amount of the revolving credit facility, and a fee of 1.75% of the face amount of each letter of credit. The Company had no outstanding borrowings on its revolving credit line at September 30, 2016 and December 31, 2015. The revolving line of credit expires on October 1, 2017.
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The Company maintains a mortgage loan with the Bank with a balance of approximately $4.7 million and $4.8 million at September 30, 2016 and December 31, 2015, respectively, secured by the Company’s corporate office building in Vancouver, Washington. This loan requires payment of monthly installments of $18,375, bearing interest at the one month LIBOR plus 2.25%, with the unpaid principal balance due November 1, 2017.
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The Company is self-insured for certain business insurance risks such as general liability, errors and omissions and umbrella coverage. Management may explore in the future whether to pursue other vehicles to provide coverage including coverages provided by the Company’s captive insurance companies.
Management expects that the funds anticipated to be generated from operations, current liquid assets, and availability under the Company’s revolving credit facility will be sufficient in the aggregate to fund the Company’s working capital needs for the next twelve months.
Inflation
Inflation generally has not been a significant factor in the Company’s operations during the periods discussed above. The Company has taken into account the impact of escalating medical and other costs in establishing reserves for future expenses for workers’ compensation claims.
Forward-Looking Information
Statements in this report which are not historical in nature, including discussion of economic conditions in our market areas and their effect on revenue levels, the effect of changes in our mix of services on gross margin, the adequacy of our workers’ compensation reserves, the effect of changes in estimates of our future claims liabilities on our workers’ compensation reserves, the effect of changes in our reserving practices and claims management process on our actuarial estimates and workers’ compensation reserves, 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 fully licensed insurance subsidiaries, the effects of becoming self-insured for certain business risks, the risks of operation and cost of our fronted insurance program with Chubb, our ability to pass on increased costs relating to the mandate to provide health insurance coverage to our clients, the effects of material weaknesses in our internal control environment, the effectiveness of our management information systems, payment of future dividends, our relationship with our primary bank lender and the availability of financing and working capital to meet our funding requirements, compliance with the continued listing requirements of The Nasdaq Stock Market (“Nasdaq”), current and future shareholder litigation, the ongoing investigations by the Securities and Exchange Commission (the “SEC”), and the United States Department of Justice (the “DOJ”), the effect of changes in the interest rate environment on the value of our investment securities and long-term debt, the adequacy of our allowance for doubtful accounts, and the potential for and effect of acquisitions, are forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. 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, 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, the effect of changes in the workers’ compensation regulatory environment in one or more of our primary markets, collectability of accounts receivable, the carrying values of deferred income tax assets and goodwill, which may be affected by our future operating results, the outcome of the examination of our federal tax returns for the years ended December 31, 2011, 2012, 2013 and 2014 by the Internal Revenue Service, the cost of defending against or settling
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Forward-Looking Information (Continued)
shareholder litigation, the expenses associated with cooperating in the SEC and DOJ investigations and the potential imposition of fines, penalties and other remedies, the costs of remediating material weaknesses in our internal control environment, the effect on our stock price if our Common Stock is delisted by Nasdaq, the impact of the Patient Protection and Affordable Care Act and escalating medical costs 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 fronted insurance program. We disclaim any obligation to update any such factors or 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 of liquid assets and its outstanding borrowings on its line of credit and long-term debt. As of September 30, 2016, the Company’s investments consisted principally of approximately $274.0 million in money market funds, $11.8 million in certificates of deposit, $5.3 million in U.S. Treasuries, $4.0 million in corporate bonds, and $3.6 million in municipal bonds. The Company’s outstanding long-term debt totaled approximately $4.4 million at September 30, 2016. Based on the Company’s overall interest exposure at September 30, 2016, a 100 basis point increase in market interest rates would not have a material effect on the fair value of the Company’s investment portfolio of liquid assets, its outstanding borrowings or its results of operations because of the predominantly short maturities of the securities within the investment portfolio and the relative size of the outstanding borrowings.
Evaluation of Disclosure Controls and Procedures
Our management is responsible for establishing and maintaining for our Company adequate internal control over financial reporting as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act.
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 Chief Executive Officer (“CEO”) and Chief Financial Officer (“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.
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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 not effective as of September 30, 2016 because of the material weaknesses in our internal control over financial reporting (“ICFR”) described below.
Previously Identified Material Weaknesses
As reported in our Annual Report on Form 10-K for the fiscal year ended December 31, 2015, management identified the following material weaknesses in internal control over financial reporting:
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Plan for Remediation of Material Weaknesses and Changes in Internal Control over Financial Reporting
The Company’s Board of Directors, Audit Committee, and management are actively engaged in the planning for and implementation of remediation efforts to address the material weaknesses identified above. The following actions have been taken to address the material weaknesses:
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Management believes the measures described above will remediate the identified material weaknesses in future periods. As it continues to evaluate and improve ICFR, management may determine to take additional measures to address control deficiencies or to modify certain of the remediation measures described above.
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 our 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.
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PART II-OTHER INFORMATION
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There have been no material changes in the risk factors included in our Annual Report on Form 10-K for the year ended December 31, 2015, which was filed with the SEC on May 25, 2016.
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Effective September 23, 2016, the Company granted a Company employee restricted stock units (“RSUs”) relating to a total of 2,000 shares of Company common stock. Each RSU represents a contingent right to receive one share of Company common stock. The award vests in four equal annual installments, commencing September 23, 2017, and is subject to continued service as an employee of the Company.
The award described above was granted pursuant to the Company’s stockholder-approved 2015 Stock Incentive Plan and issued as consideration for services rendered by the recipient. The Company did not receive any cash consideration in connection with the award.
The securities described above were issued in reliance on the exemption from registration afforded by Section 4(a)(2) of the Securities Act of 1933.
The Company maintains a Board-approved stock repurchase program, which in October 2008 authorized up to 3.0 million shares of the Company’s common stock to be repurchased from time to time in open market purchases. The repurchase program allows for the repurchase of approximately 1.1 million shares as of September 30, 2016. The Company’s credit agreement with its primary bank currently prohibits the repurchase of any Company common stock.
Exhibits are listed in the Exhibit Index that follows the signature page of this report.
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SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.
/s/ Gary E. Kramer
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EXHIBIT INDEX**
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