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Recently HQI was mentioned here and it’s potentially worth discussing. The predecessor (in a way) was called “Command Center”, a name that did not trigger attention because i thought it was about a video game involving soldiers etc. Interestingly, HQI and related businesses are often led by military-type individuals which makes sense because it’s a tough business.

The thesis: a company with an unusually enduring earning potential in a tough industry going through a messy transition related to Covid-19’s impact and an unusual reverse acquisition and led by a founder-owner-operator type equipped with capital allocation skills.

The following is a mix of fundamental comments specific to HQI with a few added (and optional) anecdotal comments.

-The Business

HQI is a US-based nation-wide provider of temporary and on-demand workers to employers in need and uses a franchisor-franchisee model. As of now, they have 217 offices scattered around the US with a concentration in Florida and Texas. The typical franchisee owns one or more ‘offices’ and is responsible for the ‘local’ management. Some aspects are outsourced to the franchisor, HQI, which oversees workers’ comp insurance, provides working capital financing and also assists the franchisees in various ways. When digging into this, it’s clear that there has been an attempt to align incentives overall.

-The Industry

Now, about 2% of the total work force is in the ‘contingent’ group. The temporary staffing industry has grown and IMO will continue to grow, possibly faster than the traditional work force market. There is a ‘dark’ side to this industry and there are various perceptions, some negative.

There are potential issues with workers’ ‘protection’ and information asymmetry and there’s always a regulatory risk. Most of the issues have been worked out and HQI is ‘the employer of record’. There’s still some uncertainty if an accident or injury occurs at work, especially if significant and especially if the ‘client’, who hires the worker through parties such as HQI, displays less than optimal security norms. With the evolution of the notion of long-term ‘loyalty’ (dwindling) and related costs between the employer and the employed, temporary staffing companies should see a growing market going forward and will continue playing a key role in providing flexibility.

The pool of workers who are typically recruited, especially in the segments where HQI has traditionally been involved, tend to be an unusual bunch, often typically the ordinary type of person who is trying to make ends meet but who may have a tendency to make questionable decisions (how to spend, save etc etc). The population of workers in the pool matters for issues of reliability, crime and injuries. Selection and retention of reasonable candidates are important.

Anecdotal: for a while, i was involved in a set-up evaluating candidates for work (pre-hiring evaluation for the typical employer and for temporary staffing agencies). For certain categories of work, drug testing was often simply dropped (still done but not used as a decision point) because the percentage of drug-free specimens was more the exception than the rule in many of these sub-groups. i had devised some kind of algorithm that included key components including the presence of unreported prescribed narcotic (opioid) substance in blood or urine as a risk factor for a workers’ comp claim (both frequency and severity of claims). Anyways.

Overall, competition is very intense and barriers to entry are relatively low.  Long-term relationships with clients can be important but this is a commoditized business. Cost control and efficiency are determinant factors for profitability and survival.

Anecdotal: i’ve recently looked into the possibility of opening an ‘office’ in my area for temporary staffing involving security guards. Although margins would likely be rewarding, if only one reasonable competitor would show up in the region, margins would go down significantly. The dynamics are similar to what may have happened at some point to margins if there were one or two newspapers in a specific area. The concept of oligopolies doesn’t work well in this space and ‘brands’ have relatively little value.

The overall temporary staffing industry has three segments. There are the very large corporations dealing with large accounts and often offering related services (head hunting for top positions etc). Those often have lower gross margins which are compensated with lower SG&A expenses. There are also very small players with one or two offices who identified a need in a specific area. In between are players like HQI. There are several categories with the low-skilled or unskilled blue-collar-worker type being the largest category.

The way it works is that staffing agencies charge clients (employers) a fee which is recognized revenue and which represents the salary and related deductions with a margin to recruit, screen and allocate the workers needed and to provide workers’ comp coverage (and to make a profit). Note that the workers get paid rapidly by the agency (often the same day) and the funds received from the employer arrive several weeks later. Staffing agencies need to have a large net positive working capital.

This is not the type of business that will do well on its own and management is a key aspect. Margins and return measures are highly dependent on an intimate knowledge of local markets’ needs and evolving trends as well as of the associated regulatory environments.

Anecdotal: An acquaintance of mine built a fairly large temporary staffing agency (healthcare sector) from scratch and sold it to a private-equity-type investor. After the sale, the agency’s numbers deteriorated for two reasons. First and foremost, the outside investor failed to adapt to changes and to clients’ needs. Second, the founder had set up a model whereby he could dispatch healthcare workers (nurses and attendants) and give those workers better conditions (pay and flexible schedule). This had given rise to a growing pool of relevant workers migrating from care centers as an employer to the temporary staffing agency pool, reinforcing the need for the temporary agency in a self-fulfilling way. The founder sold before this cycle was broken and before enough complaints reached the regional regulator.

-The Numbers and the Unit Economics

The basic thesis for HQI is related to the result of higher margins and higher return on capital as a result of alignment of incentives and optimization of cost-line-items at the basic office unit level and then to share this positive outcome through a franchise model so it’s useful to look at the unit economics.

Typical temporary staffing units can earn 3 to 5% net margins if reasonably managed. The following makes certain assumptions and the numbers are ballpark figures. For a typical office after start-up and ramp-up phase, assuming no significant recessionary activity, per year:

Revenue 2M - costs (workers’ salaries, deductions and WC coverage) – administrative expenses = 100k pre-tax profit, assuming all equity financed and no interest expense.

The costs and administrative expenses can each vary. GPM tends to be in the 20 to 25% (more 20%) range and SG&A tends to be in the 10 to 15% (more 15%) range. A 2M-revenue agency would imply a 50-100k capital investment for the ‘infrastructure’ and a 10-15% of revenue capital investment for WC, so owners of offices with a 4-5% NPM can do (very) well with return on capital measures especially if levered.

The basic idea with HQI which is the franchisor is to have a set-up that maximizes net profit margins (up to +/- 10%) through the following mechanisms and then to capture some of this increase in profitability through royalty agreements:

              1-incentives aligned, responsibilities shared

              2-0% (up to 42 days) working capital financing outsourced at HQI

              3-workers’ comp managed and provided by HQI

For 1-, this is theoretical for the future but Hirequest, pre-reverse-merger, had a long and consistent history with the model and it’s reasonable to expect better margins as a result of the set-up.

For 2-, more specifically, working capital financing is a relative barrier to entry (apart from basic management qualities and ability to spot an opportunity in the market) because the capital required is relatively large at the basic unit level. There are receivables financing options but staffing agencies often face an absence of options or relatively expensive options. The risk of staffing agencies is perceived to be high, especially at the beginning, and often the financing option implies to sell the receivables at a discount 85-90% and then to receive the balance minus a fee (+/- 5% and an interest margin) which is out of proportion to the real risk which is related to the underlying employers hiring the employees through the staffing agency. Bad debts, when ‘clients’ are selected and being part of a long-term relationship, tend to consistently run below 1%.

For 3-, even if the insurance can be outsourced (often expensive proposition, see below), managing paperwork around these issues can be time consuming and can generate additional SG&A expenses.

With the franchise model, using an annual 2M revenue base at the unit level, despite a 6.5% net royalty new expense item (6% royalty and 0.5% service revenue margin which are optional franchisor services and interest on accounts receivables financing after 42 days), the owner of the unit (because of higher margins as a result of 1-, 2- and 3-) can earn similar net income (perhaps slightly lower) but on a much lower amount of capital invested (working capital provided (and owned) by HQI).

HQI does not directly charge interest on the financed accounts receivables supplied to franchisees but effectively includes this interest charged in their royalty rates and benefits from their specialized knowledge in the area. HQI can be seen as a specialized accounts receivables financing firm and accounts receivables owned will tend to constitute a large item compared to shareholders’ equity.

For HQI’s numbers, see valuation section.

-The workers’ comp insurance aspect

People hired by staffing agencies have higher risks of workers’ comp costs (frequency and severity of claims) for a variety of reasons. The risk varies from an extra 5% to an extra 100% depending on selection, type of job and circumstances. Perceived risk is high and insurance coverage tends to be expensive. Typical rates vary from about 1 to 5% (and more) of payroll, depending on work category. So, each incremental 100 basis point movement in WC rates results in 100 basis point impact on the NPM. This is typically a significant barrier to entry and a barrier to sustained profitability. When outsourced, public pools and private insurers tend to charge high premium rates. In the US, the workers’ comp market is quite complicated and varies tremendously from state to state. Hirequest seems to have a satisfactory long-term track record in this area. They essentially self-insure for claims and have an insurance policy to cap higher cost claims (more than 500k). In general, only about 0.2% of claims cost more than 250K and 0.01% cost more than 1M. Most claims are minor and close within 90 days with a claim cost below 1K. The average claim is 30-35K as the minority of cases end up costing the most $. The bottom line is that dedicated and competent management of claims (selection of workers, allocation of workers according to skill, supply of safety instructions and equipment, actual pro-active management of claims, risk sharing with franchisees) can result in a significant improvement in the net profit margins (up to 2-3% and more).

Anecdotal: i’ve been involved in this aspect and have provided services to larger staffing agencies such as Randstad and others as well as other smaller players. The quality and competence of participants vary widely and HQI seems to be a top player.

The risk-sharing incentive provided by HQI for the WC coverage is simple and efficient, ie based on a simple reading of loss ratios and a royalty credit based on that. WC claims often take time to develop and tails can be long but the set-up appears appropriate contrary to more complex and questionable set-ups put in practice, for example by Applied Underwriters (a sub of BRK before it was sold back to the founder) and which involved a reinsurance aspect that was not properly understood by clients and regulators.

-The Management

The CEO is a central aspect to this thesis. He has a long (and apparently consistent) history with the franchise model and the way incentives can be aligned and profit potential maximized. The way the Command Center acquisition was realized is interesting and the two more recent acquisitions are potentially valuable (more on that later). A lot can be learned with Google and interested parties could look up a certain citrus orchard legal issue in Florida.

The CEO (as of end of March 2021) is 57 and owns 28% of the stock. Insiders own about 65% of the stock and many are both on the franchisor and franchisee sides of the equation. There are many related party transactions.

This can be interpreted various ways and qualitative assessment of management is difficult but, using a hockey analogy, the CEO appears to be the type who doesn’t mind ‘fighting' in corners and coming out with the puck.

-The Risks

There are the typical risks listed in the relevant disclosures.

General economic risks are significant because, in a downturn, there would be a combination of decreased demand for temporary staffing services, economic pressures on clients and possibly rising bad debts for accounts receivables and economic pressure on franchisees who owe debt to the franchisor. HQI did relatively well during the Covid-19 downturn as they benefited from the advantage of a positive working capital that tends to transform receivables into cash, as long as the downturn is not sustained.

Workers’ comp risk is also relatively significant. Loss trends can take time to develop and eventual costs can end up much higher than anticipated.

What will happen to Command Center and the newly acquired franchisees’ profitability remains a relative question mark.

A perceived risk that isn’t a material one is the potential use of online applications provided by third parties that would ‘connect’ the available worker with an employer looking for an employee, thereby bypassing staffing agencies. However, human to human interactions and services provided by staffing agencies are still essential to build the pool of workers, to properly allocate and to support the legal and regulatory requirements.

-The Recent Acquisitions

In early 2021, HQI completed two relatively large acquisitions. Both are in the staffing industry but are more oriented to the ‘commercial’ category, a category usually associated with lower (but more predictable) margins and lower WC premium rates. Looking at disclosures reveals that the prices paid to the distressed sellers were cheap and potentially very cheap if the businesses get turned around. Both Link and Snelling had poor revenue and NPM patterns even before 2020. Link was barely profitable and remains a question mark. Snelling had better profitability but leverage had become insurmountable. HQI did not assume the debt tied to the Snelling business so the close to 3% pre-tax margin can be reasonably expected to be built upon.

As a result of the two acquisitions, HQI used a total of 9.2M from a line of credit on top of cash on hand.

-The Valuation

HQI, in itself, is relatively straightforward. They use two main royalty models and they have various royalty credits in place (for lower margin lines, to encourage expansion and to risk-share WC). The bottom line is that it’s reasonable to expect a net gross 6.5% royalty and service revenue from franchisees based on system-wide sales and a 3.5-4.0% net profit margin on system-wide sales once the dust settles down from Covid-19 and when acquisitions are integrated and running more efficiently.

Pro-forma system wide sales for 2021 can be approximated to 438M and it would be reasonable to expect system-wide sales at around 500M within a year or two.

From gross revenue: 500M x 6.5% - adjusted for size SG&A of 13M = 20M pre-tax

              -effective tax rates are expected to remain low because of WOTC and related tax credits

From revenue to the bottom line: 500M x 3.5% = 18M

Shares outstanding: 13.6M

They have started a dividend in the last two quarters of 2020, 0.05 per share.

Assuming they reach 1.50 per share in two years and grow EPS 15% per year for three years after and using a PE of 20 in 5 years, I get a compound annual return of 18-20% over the five-year period.

And then you potentially get a company which will continue to report high returns on capital and which has room to grow market share in a growing market.

-Conclusion

A company in a tough industry, with a solid model and owner-operator, going through an unclear period due to Covid-19 and some kind of transformation and with the potential for high returns on equity and growth (organic and through acquisitions).

Disclosure: no position yet

Questions are welcome but would prefer ruthless attempts at destruction.

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I've owned this since the merger with CCNI (though I added a lot more last March during the start of the pandemic).  Actually - I originally purchased my shares at $5 as a special situation arb thinking I would tender into the tender offer that came about as a result of the reverse takeover. (HQI was private but was actually the acquirer of Command Center - the public company).  The tender was done at $6 to reduce the share count from the merger in order for HQI to retain control.  But when I started to read the proxy and learn about HQI I realized that this mgmt team and their business model was something special.

CB - I think you've covered the industry and the background.   But I think there are a few key differentiators to the way HQI runs the company that are a bit different vs most of the industry players.  I hope you don't mind me adding a bit of colour to your excellent summary.

1) The branch locations are 100% franchised.   Even the Command Center locations which were acquired were either sold off completely (eg. California due to Worker Comp dysfunction in that market) or sold to franchisees (many of them the principals who run HQI).

2) The business model is very important here.   The employers pay their invoices every 30-45 days but the temp labor pool gets paid daily or weekly.  This can create working capital mismatches for the branches.   HQI owns all of the systemwide receivables and collects all of the cash from employers but remits payroll reimbursement to all the branches just-in-time as temp labor gets paid.  It remits the remaining amounts owed to the branches as receivables are collected (ex HQI's royalty fees and other fees) but will holdback any amounts not paid by employers.   

This has two advantages:  

- The branches can run on basically no working capital and lean overheads - so branch-level ROI is maximized and no working capital is tied up at the branch-level.  That makes franchisee start-up costs and economics very light.

- HQI can also run leaner in terms of SG&A because it doesn't have to manage the branches much.  The A/R holdback aligns the branches' incentives to go after their employers who don't pay/late pay on billings.  Also for HQI, holding the receivables is counter-cyclical.  Last year during the pandemic, as demand for temp labor fell, HQI was slowly liquidating receivables which was a source of cash for HQI and kept them very liquid.  Meanwhile - because the branches were independent small businesses, they all could file for PPP money (which HQI didn't do).  

I really like the HQI management team.  They are smart and entrepreneurial.  They took advantage of the pandemic to make acquisitions that fill in their network and put them in adjacent markets.   They are also connected to Dock Square HQ, LLC (the Bush family's investment arm led by Jeb Bush) - so they have connections to large national employers through the Bush family through a negotiated financial arrangement between HQI and Dock Square.

Its a tough industry but the way this management team went public (thru CCNI) and then turned the pandemic into an opportunity is very impressive.  Even though HQI is up a lot - I think I want to continue to ride with these guys.   A warning though - there's a lot of related-party transactions going on here.  As I said, a large number of the branches are also owned by management.  I think one of the principals owns a small insurance company which HQI contracts with to get its workers comp insurance.  If that makes you uncomfortable - then this company is not for you.  But I trust these guys - so far they haven't given me a reason to not trust them.

wabuffo

Edited by wabuffo
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^

-lean overheads and lean SG&A part

They suggest that their model combined with a national presence results in less middle management positions (ie regional and territorial managers etc) and it's a reasonable suggestion. There's seems to be an unrelenting-will-to-go-after-costs type of culture which is essential in this type of business. 

-on the California WC's dysfunction part

It's possible to make money when WC is involved in California. Just look at Zenith National, an insurance company focused on CA's WC insurance market, a company i've followed for a very long time and which was acquired by Fairfax some time ago. The WC market in California was quite dysfunctional about 20 years ago when there were attempts at deregulation. Many insurers fell like dominos. Now, CA's WC market is more similar to the rest of the country. The more recent problems may be related more specifically to the temporary staffing industry. Despite heavier regulations (i'll be careful here to avoid attracting carnival barkers with unusual pollitikal intents), in the temporary worker space, there seems to be more creative entrepreneurs who forget to remit payroll tax and there's even mention of a parallel and underground market for WC coverage, involving also undocumented workers. Also, in California, the average claim is more than the national average, typically takes longer to settle and 'administrative' costs are higher as a % of payroll. Simply stated, California is a different beast for staffing agencies and it remains an opportunity to be studied (the California market is more significant in size compared to Canada, FWIW). HQI does have a presence in CA through a basic  licensing agreement (10 offices divested (HQI still has distressed money owed to them from this..) from Link and Snelling acquisitions) with 2020 19M SWS but this is not material from a numbers' point of view although it may offer an observation post to better understand the market before trying to conquer it.

-on the Bush family office part

Yes, i saw a video of Jeb Bush promoting a philanthropic venture initiated by the CEO. A lot of this business is word-of-mouth both locally and i guess at higher levels also.

-on the related-party transactions and related sub for WC management part

This a concern and the question is how far some people who are good at spotting opportunities for profits are ready to go. The set-up seems to neutralize, at least partially, the concerns here. My understanding of the privately held insurance company is that it will handle the legacy (before merger) WC aspect and, going forward, this will be handled in-house (ie within HQI). They continue to use though a related party brokerage firm for insurance policies with commission income of about 70-100k per year.

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Recent interview; the CEO does a nice job explaining the advantages of the franchise model vs corporate owned; incentives, and de-centralization. 

Thanks for another unique idea, Wabuffo & Cigar.

 

P.S. Re paying workers daily - <'"The vast majority of these payments were made via electronic paycard.".>  Wabuffo, no doubt this is through Meta Bank! 

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FWIW, I EM'd their general counsel because the 10-K reads as if they completely self-insure worker's comp. Which sounds crazy to me. But he got back to me ( in 10 minutes) and said they buy coverage for claims excess of $500,000. And they avoid industries with potential long-tail exposures.

I'm hyper- sensitive to the issue, as a Californian and former insurance guy. The fact they avoid CA comp altogether is heartening. I don't think Berkshire has even solved WC here.

 

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8 hours ago, Libs said:

FWIW, I EM'd their general counsel because the 10-K reads as if they completely self-insure worker's comp. Which sounds crazy to me. But he got back to me ( in 10 minutes) and said they buy coverage for claims excess of $500,000. And they avoid industries with potential long-tail exposures.

i suspect that excess WC insurance coverage is a requirement in many (most? all?) states in order for them to self-insure. There is a market for these specific high-deductible excess of loss per claim policies. In fact, the market appears to be somewhat competitive (low expense ratio as the self-insured does most of the administrative work and loss ratio based on a large amount of historical data). Also, HQI has a long history of underwriting to help the insurer assess if their profile fits with existing data. The key is to retain most of the WC risk and reduce related costs. This is why an aggregate-type of excess loss protection based on a specific loss number in total would not make sense for HQI who is trying to extract value from the risk they manage (and to share this with franchisees). The idea of putting a cap on 'catastrophic' cost is relatively inexpensive and removes the uncertainty of a low-probability claim associated with high costs and a very long tail (duration). These 'catastrophic' risks are associated with certain jobs but often it's simply bad luck ie somebody falling in a flight of stairs (while on the job premises) and becoming paraplegic. 500k though is a high deductible and an office (if the cost would be allocated to that specific office) hit with such a claim would see its profitability reduced over many years. Long-term and big-picture thinking required.

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