2023-12-21 01:33:49 ET
Summary
- TriNet's stock has been performing well, nearly doubling since November 2022 and up 21.5% since last quarter's earnings report.
- Key performance indicators to watch include WSE user growth, insurance cost ratio, and growth in HRIS users and/or revenue from Zenefits acquisition.
- TNET is executing its KPIs, with growth in new annual contract value, improvement in retention rate, and growth in HRIS revenue during Q3.
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Investment Thesis
TriNet Group ( TNET ) has been executing on its company KPIs, and improving new sales and retention throughout 2023, potentially setting itself up for sustainable growth. TriNet's Insurance Cost Ratio ((ICR)) continues to beat expectations and contribute to expanded margins. There is reason to believe this could continue. Now that Zenefits, acquired in early 2022, is fully integrated into its suite of products, TriNet has a larger TAM, increased optionality, and a more robust technology platform. Zenefits may be the key driver of future growth and could make TriNet stock a lucrative long-term investment going forward. Despite its performance in 2023, TNET stock appears to be fairly valued to undervalued.
TriNet's KPI Execution Should Support The Stock Price
TriNet's stock has been on fire lately. It's nearly doubled since its low in November of 2022 and is up roughly 22% since a brief sell-off following last quarter's earnings report. However, the growth of this Human Capital Management software and service provider for small businesses appears to be far from over.
Let's dive into what investors should be looking at following a solid Q3 earnings report to be confident that management's strategy is building long-term value for its customers and shareholders.
With a history of market-beating returns, accretive acquisitions, strong leadership, and profitability, is TriNet Group worth investing in after its run-up in price?
To answer this question investors should look at the most important key performance indicators (KPIs). Improvement in these KPIs will drive positive business results and could deliver great shareholder returns. Three KPIs that I believe are the key to understanding the value of TriNet stock are WSE user growth, Insurance Cost Ratio, and growth in HRIS users and/or revenue contribution from TriNet's recently acquired Zenefits.
Q3 Earnings Summary
- Improving new sales, and retention, with a resilient customer base.
- 42% growth in new Annual Contract Value ((ACV)) during Q3.
- Expect a 6% improvement in full-year retention rate.
- 42% HRIS (Zenefits) revenue growth, YoY.
- TriNet expects to perform well in Q4 and 2024.
- Insurance Cost Ratio continues to beat guidance.
- Completed a $1 billion buyback to boost shareholder returns.
TriNet Group Background
TriNet Group is a PEO (Professional Employer Organization) and Human Resources Technology provider. TriNet earns most of its revenue from its PEO offerings by providing a suite of healthcare and worker's compensation insurance and other benefits, and HR management tools insurance to over 330,000 worksite employees (WSEs). Additionally, TriNet earns revenue through two recent acquisitions: TriNet Zenefits, a Human Resources Information System ((HRIS)) company, and Clarus R+D, a Research and Development Tax Credit service.
Since becoming public, TriNet has outperformed the S&P 500 and the Nasdaq (SPY and QQQ) by a wide margin.
TNET has crushed the market since going public. (Stratosphere.io)
Let's examine the KPIs that will be the catalyst for growth.
KPI #1: Growing WSEs Is Key To Accelerating Revenue
TriNet's Worksite Employees (WSEs) User count is the most important driver of the business. WSEs are the company's main customers and consumers of its services and account for over 90% of Professional Services Revenue and the entirety of Insurance Services Revenue. TriNet's average WSE user count declined throughout 2022 and during Q1-2023. Average WSE User count also declined 5% YoY in Q3, driven by weaker hiring among its client base, a lack of sales capacity, and lower retention throughout 2022. However, WSE users appear to have bottomed out in Q1 and returned to growth. Will this trend continue?
Average WSE Count by Quarter (TNET) (finchat.io)
The company has reported positive developments within all three of its KPIs during each of its 2023 earnings calls. In each call, management has sounded more confident than the last.
TriNet's company KPIs and key drivers of growth in WSEs are retention of existing WSEs, new sales, and the net hiring of TriNet's installed base (the SMBs that hire TriNet's WSEs); this is referred to as CIE (Customer Improvement in Existing) by TriNet.
Retention Of WSEs
During Q3 , TriNet's trend of improving retention continued. Management boasted that its full-year retention rate is now expected to be in line with TriNet's all-time best mark, with a 6% improvement expected over 2022.
The company appears to be executing on its retention strategy. TriNet CEO, Burton M. Goldfield attributed this to its differentiated HCM and PEO model and its improving Net Promotor Score.
Because many of their customers sign annual contracts, positive developments in retention rates throughout 2023 might lay the foundation for growth into 2024, as long as TriNet can continue improving its new sales beyond what it has already achieved throughout 2023.
Improving New Sales And ACV
In 2022, a lack of sales capacity was a significant reason for TriNet's decline in WSE count. The company addressed this in the second half of 2022 by increasing its sales rep count by 19%. The chart below shows the acceleration of new sales ACV and sequential QoQ growth in ending WSE users throughout 2023.
TriNet has been accelerating new sales (ACV) and increasing WSE Users throughout 2023 (Author generated Chart (with data from TNET 2023 10-K & 10-Qs and earnings transcripts))
It appears that TriNet's investments in growing its sales rep count have been effective. Furthermore, TriNet management stated that its sales team is only expected to improve as the reps become more familiar with the company. The company is projecting ACV to accelerate in Q4 and Q1 of 2024.
Hiring Outlook Of Installed Base
Throughout 2023, management has stated that its Technology vertical has shown weaker hiring trends but that hiring among its clients has held up pretty well.
In Q2, TriNet management mentioned that net hiring increased in five out of its six industry verticals in June, reversing a trend of a softer hiring environment throughout H1. The only vertical without net new hiring was its Technology vertical. Even in the Technology vertical, TriNet saw a slowing in headcount reduction. During the Q2 earnings call, management was cautiously upbeat about hiring of its customer base. During his remarks, CEO Goldfield stated , "we are encouraged by our customer hiring. While still early we are starting to see some positive indications that CIE may begin to normalize."
Customer hiring in Q3 was mixed, with half of its verticals experiencing headcount growth, while technology, non-profit, and professional services saw workforce reductions. In response to an analyst question about TriNet's ability to achieve WSE growth in 2024, despite a softening labor market, Goldfield said this, "With a flat to a couple percent CIE, that becomes a significant challenge, but I also believe our diversified customer base and by the way, some of the external studies that we've done, where new business formation is way up, I'm still optimistic about the future."
Overall, the U.S. labor market remains resilient, strengthening the case for TriNet's CIE to support WSE growth given its strong retention and new sales performance, and 2024 outlook. This will need to be monitored as the macroeconomic environment shifts into 2024. If we see a trend of weaker hiring in Q4 or early 2024 in TriNet's verticals or throughout the U.S. labor market, the growth outlook for TriNet may turn negative.
WSE's May Return To Growth
TriNet has significantly improved its new sales, its retention is trending positive, and its installed base has shown signs of resiliency during 2023. Because of this, TriNet expects further WSE growth in Q4, including the critical new sales cycle leading up to 2024. I want to see continued improvements in TriNet's average and ending WSE User counts to confirm that it is on the right track. When we get full-year results in February, management's discussion will explain how 2024 is shaping up. If new ACV growth in January is solid, and retention and CIE improve, TriNet should be in for a very strong 2024, and the stock could catch a big boost.
Despite its recent challenges, the long-term growth trend of TNET appears intact. I believe TNET's WSE count will resume its long-term growth trend going forward.
The long-term trend of WSE growth may continue despite a hiccup in 2023. (www.finchat.io)
KPI #2: Insurance Cost Ratio Driving Increased Profitability
In addition to growth, investors want to see TriNet improve profitability too. One of the main drivers of margin expansion and increased profitability has been the gradual decline (improvement) in its Insurance Cost Ratio ((ICR)). ICR is the total cost of insurance claims divided by the premiums collected. A lower percentage is better, indicating the company is making a profit on every benefit plan it sells. A 90% ICR equals a 10% gross margin on insurance services.
TriNet reported an ICR of 84% during Q3, which beat the high end of its guidance by 3.5% (Q3 guidance was 89.0% - 87.5%). A significant contributor to this beat was a continuation of lower healthcare services and worker's compensation expenses than before the pandemic. This resulted from the trend of increased work-from-home policies, which led to lower workers' compensation claims, and a reduction in nonessential healthcare visits that has not returned to pre-pandemic levels. The company also updated its FY-2023 ICR outlook, once again reducing the guidance range by 1.5%, to a range of 85.5% - 84.5%. For perspective, a 1.5% improvement in ICR equates to roughly a 1.3% improvement in Gross Margin for FY-2023, or $63m. This continues a trend of TriNet conservatively guiding for ICR, then beating on ICR. But more importantly, shows a continued focus on this key metric, and how it has been improving it significantly since TriNet came public.
Here is how ICR has improved since FY 2014.
TriNet Group Insurance Cost Ratio (ICR) 2014-2022 (Author-Generated Chart)
This reduction in ICR has been vital to TriNet's expanding gross margins. There is an inverse relationship between ICR and Gross Margins. As ICR decreases, GM increases. These two numbers are closely related because 90% of total revenue comes from its Insurance Services.
Inverse relationship between declining ICR and Expanding Gross Margins (Author-Generated Chart)
Is ICR sustainable?
The key question investors should be asking is, "Are these gains sustainable?" A significant portion of this decline in ICR is attributable to pandemic-related changes in healthcare utilization. There was a reduction in healthcare visits made by TriNet's WSEs that began during the pandemic and is beginning to normalize throughout 2023. The main drivers of TriNet's lower-than-expected actual and forecasted ICR are due to lower expenses on worker's compensation and health costs. Risks to ICR increasing are a return to the pre-COVID normal volume of outpatient procedures, rising pharmaceutical prices, and increasing premiums.
Major health insurers have been raising their premiums, potentially creating a double-edged sword for TNET. As healthcare costs increase, SMBs may find a benefit in TriNet's economies of scale and lower pricing of healthcare policies. However, increased insurance premiums may provide near-term headwinds to profitability if TriNet is unable to pass the costs on to its clients and WSEs, driving up ICR and reducing margins. However, it appears that TriNet has been able to renegotiate broker agreements, as was mentioned during the Q3 earnings call. This provides reason to believe that TriNet will be able to negotiate favorable pricing.
This decline in insurance costs is not expected to last indefinitely; therefore, it is essential to track TNET's ICR over the coming quarters, and it's likely to rise. Management has consistently guided to an ICR above what it has actually achieved. If TriNet can keep ICR lower than its historical average, it will be evidence that TriNet is continuing to do a better job with pricing to risk (underwriting) for its insurance products.
KPI #3: HRIS Users And Revenue
The Zenefits Acquisition May Be Key To Unlocking Long-Term Growth
TriNet acquired Zenefits, in December of 2022, with the goal of improving new sales by acting as a new sales funnel for small businesses not ready for a PEO, improving retention by helping TriNet hold on to businesses that grow out of the PEO model, and expanding its TAM to the entire SMB market. TriNet also wanted to leverage Zenefits' superior cloud-native tech platform to improve TriNet's own PEO model. Zenefits is currently a small piece of TriNet's revenue stream but serves a critical part in its growth plans.
The acquisition of the Zenefits Technologies helped TriNet transform into a single-cloud native platform. Since then, the company has fully integrated its legacy PEO platform and the Zenefits HRIS platform to create the TriNet Integrated Open Market ((IOM)) brokered benefit offering. IOM allows TriNet to offer its full suite of PEO and HCM solutions to SMBs through a single platform with a common user experience. IOM also allows SMBs to tailor their benefits and HR needs to their unique business needs and to attract talented employees.
Rather than remaining a niche PEO provider for businesses with 5-100 employees, TriNet now provides a more differentiated offering from its competitors and is able to serve its clients' needs throughout their entire business lifecycles. A company may start its journey with TriNet within the Zenefits HRIS platform, seamlessly move into its PEO platform as it scales and needs higher touch HR and benefits services, and then just as easily fall back into the Zenefits HRIS platform as it becomes large enough to take its HR in-house. As a young company, this SMB was able to leverage TriNet's scale to offer benefits commensurate to those of larger companies. As a PEO customer, the company allowed TriNet to take on the legal responsibility of managing HR and benefits, allowing its management to focus on taking the next step in company growth. As a larger SMB or burgeoning enterprise, the company now has its own ability to manage HR but has the option to maintain the same user face and platform that its employees have been using for payroll, benefits, and other HR functions while bringing its own benefits into the Zenefits platform.
Could Zenefits Be On The Cusp Of Generating Big Returns?
The strength of the Zenefits acquisition is not in hyper-growth but in its cumulative effects on the business as a whole.
During the Q3 call, TriNet CFO, Kelly Tuminelli, mentioned that the company had optimized broker agreements and experienced a revenue benefit for Zenefits, increasing Zenefits' revenue contribution to $17 million for the quarter. This represents an increase of 42% versus Q3 of 2022. The revenue growth from Zenefits was a positive surprise, considering that TriNet has been shedding HRIS users since acquiring Zenefits.
HRIS Revenue by Quarter (TNET) (www.finchat.io)
Average HRIS Users have fallen from roughly 231,000 in Q1 to 211,000 in Q3. My expectation was that HRIS users would have to bottom out before TriNet would be able to accelerate revenue contribution from this part of the business. However, the company appears to be able to optimize Zenefits somewhat, achieving revenue growth despite a lower client count. Tuminelli also stated that most of the acquisition and integration costs for Zenefits are decreasing. The combination of revenue growth and cost reductions in H2 is the perfect setup for a successful 2024 for Zenefits.
HRIS User Count (TNET) (finchat.io)
Tuminelli also reiterated the company's expectations that Zenefits would break even in 2024. The acceleration in Zenefits revenue, despite the weaker hiring environment that the company has faced throughout H2 2022 and through Q3 of 2023 shows increased efficiency from Zenefits. Tuminelli mentioned that this optimization is strengthening its PEO-brokered benefits offerings. Fully integrating and optimizing Zenefits may allow TriNet to make the Zenefits acquisition accretive to the PEO business over the long run.
If TriNet successfully grows its Zenefits HRIS business, it can do more than just add marginal revenue, it could drive growth in the PEO business by widening the PEO sales funnel, boosting retention, and opening the door to a broader set of SMBs. The marriage between TriNet PEO and Zenefits has provided the company with an avenue to continue growing; if successful, it may take shareholders along for a very profitable ride.
Does TriNet Have an Attractive Valuation?
Even though TriNet looks like its business is on the upswing, investors don't want to overpay for the stock. To determine if TNET is a good investment right now, I have created two reverse DCF models (base case and bull case) based on Free Cash Flow.
TriNet's Free Cash Flow numbers can be deceiving because they are lumpy. This is largely due to the variable timing of contract payments. To normalize Free Cash Flow, we can utilize a metric that TriNet reports called Corporate Operating Cash Flow (COCF). COCF allows for easier comparability of operating cash flow between periods.
Below, you can see the huge variation in FCF and COCF in single periods. The trend for both, however, is up and to the right. If anything, FCF is trending slightly higher than COCF.
COCF vs. FCF, COCF paints a clearer picture of TriNet's operating cash flow trends (Author generated - using TNET COCF & FCF from SEC Filings)
To determine a reasonable estimate of FCF growth, I have reviewed several COCF and FCF growth periods. I am basing my forward FCF growth assumptions on the 12.9% CAGR in COCF that TriNet achieved from 2015 to its most recent TTM period, albeit more conservatively.
Comparison of COCF & FCF growth over multiple time periods. (Data taken from TNET 10-Ks and 10-Qs, 2015-2023.)
Historically, TriNet has converted COCF into FCF at a rate of 88%. If TriNet has a solid Q4, achieves $450m in COCF for FY23, and converts 88% of COCF into FCF, we get $396m of Free Cash Flow for 2023.
To double-check my forward FCF growth estimates, I have also examined COCF and FCF per share. TNET has steadily reduced its share count through buybacks, increasing COCF and FCF per share faster than the whole numbers.
To be conservative, I have modeled 2024 as a year with very little growth in cash flows for TriNet. If we assume that TriNet doesn't grow 2024 FCF or COCF beyond my FY 2023 assumptions ($396m and $450m, respectively), the dramatic reduction in shares and operating leverage that TriNet has supports a cash flow growth rate as high as the mid-teens.
FCF per share and COCF per share has grown at a fast rate. (Author Generated with data from SEC filings)
Over the past nine years, TNET has grown COCF at 12.9% and it looks like it can reasonably grow it around 16.1% in 2024. With FCF tending to grow faster than COCF we can conservatively estimate FCF growth.
I will use a forward FCF CAGR of 8% for my base case, and my bull case will use a 12% forward FCF CAGR.
Base Case
If we run a reverse DCF with the key inputs being a Terminal Value of 2.0%, a Discount Rate of 11.0%, and an FCF Growth Rate of 8%, TNET's intrinsic value is $125.19, making the stock currently undervalued.
Base Case: Reverse Discounted Cash Flow Analysis (Assuming 8% FCF CAGR) (Data: Generated by Author; Calculator: www.BrianFeroldi.com (with permission))
Bull Case
If we run a reverse DCF with the key inputs being a Terminal Value of 2.0%, a Discount Rate of 11.0%, and an FCF Growth Rate of 8%, TNET's intrinsic value is $160.35 and the stock is currently undervalued by over 30%.
Bull Case: Reverse Discounted Cash Flow Analysis (Assuming 12.0% FCF CAGR) (Data: Generated by Author; Calculator: www.BrianFeroldi.com (with permission))
This makes TriNet Group stock appear to be attractively valued despite the run-up in price that the stock has experienced. I believe the company will perform well going forward and have added to my position since it reported earnings in October. I will not hesitate to add to my position if the price falls below $110 or if the growth outlook for TriNet improves further and a higher price is justified.
Risks to Thesis
Labor Market Pressure
TriNet Group operates within a cyclical industry, and its growth prospects rely partially on hiring within its customer base, which is out of its control. If the economy struggles and unemployment rises, it will negatively impact TriNet's ability to grow.
Normalization of Insurance Utilization
TriNet's ICR is expected to rise somewhat. The company does a great job of conservatively guiding and then exceeding expectations. However, if workers' compensation and healthcare utilization increase to pre-pandemic levels, it will put pressure on the profits that TriNet captures from its insurance services. TriNet will need to maintain the long-term trend of improvement in ICR in order to maintain the expansion of margins it has enjoyed since 2020.
Lack of Realizing the Benefits of the Zenefits Acquisition
TriNet's Zenefits acquisition has me feeling bullish on the company's long-term growth outlook. Even though this part of the company may become profitable in 2024 and appears to be benefitting the potential of the PEO side of the business, it is not a guarantee that TriNet will be able to capture a large enough portion of the HRIS/HCM market. HRIS revenue increased 42% YoY during Q3, but I would like to see the number of HRIS users increase for several quarters before I declare Zenefits a success. If it continues to shed users, no amount of Zenefits optimization will matter.
Conclusion
TriNet Group has a history of outperforming the S&P 500 and Nasdaq and may surprise investors with higher-than-expected growth over the next five to ten years. The key to unlocking this growth is in Zenefits, with its HRIS revenue growth and the technology and optionality that Zenefits provides to the PEO business. Long-term trend improvements in the Insurance Cost Ratio and a resumption of WSE growth will be another critical part of my thesis for market outperformance.
The stock trades in a fair to undervalued range. However, if the company announces that it has made further improvements in its company KPIs, such as an accelerating WSE count, further improvements in retention, and continued acceleration of new sales, a re-rating would be required. This could make the current price grossly undervalued and provide market-beating returns.
For further details see:
TriNet Group: The Future Looks Bright Post Its Q3 Earnings