Aventine Asset Management Inc.

A High-Quality Canadian Growth Story 

Investment Thesis
July 2017

We believe People Corporation (PEO.TO) is in the early stages of becoming a staple in small/mid cap portfolios across Canada. Through a successful rollup strategy executed to date in the Canadian human resource space the management team at People has proved themselves to be excellent capital allocators, prudent deal makers and effective executers. We model topline revenue growth of +300% by 2020 and believe that People is currently in a sweet spot where the story is still relatively unknown by retail/institutional community, but the company’s market capitalization is now large enough to get on the investment radar. Valuation today is very reasonable for a high revenue growth company and we see future share price returns through a combination of earnings growth, multiple expansion and the incremental benefits of a broader shareholder base. By our math, People conservatively offers 50% upside over the next 2-3 years with potential for even higher returns if they increase their cadence of accretive acquisitions. In summary, People’s acquisition pipeline, double-digit organic growth, recurring revenue model and scale-driven margin expansion, present an attractive opportunity to own People shares at these levels and to potentially expect People to be a core position in the ACE Fund for several years.

Our Investment Process

The ACE Fund follows a disciplined and repeatable process which includes both quantitative modeling and fundamental analysis. At a high level, we seek to own a concentrated basket of undervalued Canadian stocks that have shown market support over an extended period of time (i.e. long term momentum). Our goal is to be shareholders of undervalued companies as operational improvements or other catalysts are realized, which results in multiple expansion and a corresponding acceleration of market support, liquidity and institutional ownership. By focusing our efforts on this particular investment objective, we often benefit from share price appreciation that is dually driven by both higher future earnings and a higher future earnings multiple. The momentum requirement contained within our investment approach also helps us avoid “value traps” as we tend to focus on companies trading close to 52-week highs versus 52-week lows.

Our quantitative process looks for companies exhibiting strength in several operating metrics including growth in EPS, Revenue, ROE and margins. We also look for companies whose stock prices are demonstrating strong long-term market support (ie. trading above moving averages with increased volume on support thresholds). This stage of our process is run by our multi-factor proprietary quantitative model that is geared to find stocks that exhibit these characteristics. As you can see below, People first crossed our buy threshold for potential new investment in May and steadily improved through the spring, prompting us to dig deeper. Our model has done an excellent job of uncovering some of the most remarkable success stories in Canada before they were well known, several of which we still hold today.

We are active managers who set strict sell parameters based on valuation and quantitative ranking. We believe that there are structural changes long underway in the public markets and specifically through the changing forces of the various participants of the public markets (ie. exchange traded funds) which allows such a style of “mid-stage pile on investing” to generate above average returns for investors whom are willing to incur reduced tax efficiency through more active turnover than most mutual fund companies in Canada. By recognizing the inefficiencies occurring around us in the public markets we can produce superior returns over the long run.

Our experience over the years as both quantitative analysts and private equity investors has taught us that there is more to owning companies than buying and selling pieces of paper. We also recognize that a company can look good on “paper”, but can actually be a very weak business based on management, competitive advantage, financial structure, etc. After we identify a candidate for the portfolio via our quantitative model we perform our own in depth due diligence. This will include reading transcripts, meeting management, identifying the appropriate valuation methodology and talking to customers and competitors.

Target Company Overview

People Corporation offers group benefits, group retirement and human resources services (“HRS”) to small and medium size enterprises (“SMEs”) across Canada. The Company earns commissions and fees from insurance carriers and clients for providing group benefits solutions and fees from its clients for other human resources-related services. They currently have 625 professionals and staff in 36 offices across Canada. In the past several years, the Company has expanded its service offering, mostly through acquisition, in order to create a platform for organic growth from existing customers and acquired companies. People has done an excellent job making sure they not only cover the major customer groups (public, private, union, etc.) and geographies, but also to make sure they pivot the business to be much stickier from a recurring revenue and retention point of view. We believe this strategy has opened up significant opportunities for cross selling and value-added services which should continue to add to organic growth for years to come. According to numbers from Stats Can the addressable market for People is $1.9b in annual revenue which means they currently have 4-5% market share.

The original business was 100% transactional in nature (called People First HR), as in hiring services, which is a tough business and one we would not be interested in. Over the years however they have significantly altered their revenue mix as you can see below. The original hiring services business, along with consulting, now only makes up 10% of the business.

REVENUE BY SECTOR

The Third Party Administrators (“TPA”) revenue is of most interest to us given both its importance to the business today its size and the fact that that People controls all the data as such data sits on their internal systems. For example, customers who use their TPA platform get a “People Card” which means everything runs through People as they administer the claims. If you are a small business and you want to hire someone else to provide a more comprehensive or more cost-effective benefit coverage plan, you can still work with brokers at People who will help customize a solution for your company on life insurance, medical insurance, dental, etc. They can use any of the providers for these services so it adds a further element of customization versus dealing with just Sunlife or Manulife for example. Their experience has shown these customers remain on the platform for 8-10 years. This is a sticky business and one which we view as very valuable. Revenue comes in the form of consulting, commission and recurring fees.

The Brokerage business includes 9 different subsidiaries that provide unique and proprietary employee benefits, group retirement and human resource solutions. These are customized solutions, but utilizing different plan administrators. If you are a small business and want to add life insurance to your company plan you may hire one of the People brokers who will shop around to find an option that works best. In this case People is simply earning a commission from the insurance carrier.

People’s transformation into a Brokerage/TPA business did not happen overnight. It was a slow and methodical change, outlined below:

 

Management Team

Insiders are very well aligned with current shareholders and currently own 22% of the shares outstanding, led by CEO/Chairman Laurie Goldberg at just north of 10%. While the entire team at People is impressive we are particularly impressed with Laurie’s background as he was instrumental in executing a multi-year growth by acquisition strategy at Assante Wealth Management (Laurie was COO of Assante between 1998 and 2003). During this period, Assante acquired 18 subsidiaries within their investment advisory network and Laurie was instrumental in selling the Assante business to CI Financial in 2003. We have been very impressed with his patience and vision for People and as the chart of his own insider purchases in the company’s stock shows, his own support and belief in the future of the company and the growth potential of its share price remains very strong, even as the company’s share price has grown significantly over the past six years.

Laurie Goldberg, Executive Chairman and CEO 

Insider Transactions since Q3 2010 (note – only buys, he has sold 0 shares)

We were also pleased with the recent addition of Dennis Stewner as CFO and COO, whom we believe will be instrumental in taking People to the next level. His relationship with Laurie goes back to the Assante days in the early 2000’s which we believe makes this a great fit. Dennis was most recently with National Bank where he was responsible for the bank’s Canadian full service brokerage business outside of Quebec.

The board of directors is not as strong as we would like from an independence point of view, but they did bring on Eric Stefanson in late 2014 who has significant experience from being on the board of The North West Company (Chair of Audit Committee) and Via Rail (Interim Chairman). Eric was the past CFO of Assante, so he does have a prior relationship with Laurie. We would like to see a deeper level of independence on the board in the coming years.

Competitive Landscape

People’s market is Canada which makes their universe very easy to understand. There are a handful of large players in the market (Towers Watson, Mercer, Morneau Sheppell) and many independent regional human resource consulting firms. The large players focus on government and the biggest companies in Canada which the regional players focus on small/mid sized businesses in their respective geographies. Given that 50% of employees in Canada work for small/mid sized businesses we believe that this provides a large runway for People to grow their market share, especially now that they are an established player.

While People has progressed this far without a unified brand we believe that in the years to come they will bring all the independent brands they have acquired under the People umbrella. It is a natural progression and one which we believe will further enhance organic growth. When you couple the eventual branding with the power of integrated systems and sales we believe that it will only make their value proposition that much greater for both business owners to sell and also for customers. HR consulting is not a large moat business, but it is a relationship business and Peoples focus on TPA (for stickiness) and size definitely puts them in a favourable competitive position as they look to grow organically in the various regions where they have a presence.

While there are also new entrants in the employee benefits business (League) offering customization and individually tailored solutions for employees, we believe that such modifications and customizations can be easily adapted by parties which already have established Third Party Administration relationships with companies’ employee databases as popular new customizable plans gain traction.

Acquisitions / Pipeline

People Corp. has been very active on acquisitions since 2007 (see list below). The market for providing group benefits to SMEs is highly fragmented, which provides many opportunities for future acquisitions and the further development of the Company’s platform. The acquisitions follow a strict formula. Good talent with little disruption, accretive to EBITDA from day one, and opening new channels for continued growth under the People banner. In most cases, People will buy a majority stake in the business with earn-outs based on EBITDA targets in place. Then based on meeting certain growth objectives, People will buy out the remaining portion of the business at a similar (very attractive) valuation. All in all, this makes for a very attractive sale proposition to parties who otherwise would not be shopping their business. Effectively the seller will receive upfront proceeds at 5-6x EBITDA, enjoy the earn-out along with management salary’s and bonuses, and enjoy an option on the remaining stake that they know People will buy if/when growth objectives are met. We have seen this model work very well with companies such as FirstService (FSV.TO) where they have a robust acquisition pipeline, but also have the option to purchase EBITDA at a very good valuation in between deals. This deal structure decreases the lumpiness and in our view should support the valuation multiple of People.

We believe People will pick up the pace of acquisitions over the next few years as their experience has grown and as word has spread that there is a buyer/partner out there for business owners in the space. As the CFO Dennis Stewner said to us recently on a call “the pipeline has never been stronger because they have grown and are now getting many inbound calls”. We believe it is possible to see greater than one deal per year for the next few years and we do not believe this potential upside is adequately captured in the current sell-side analyst’s models. Regarding analysts, there are only four analysts currently cover the stock, which we view positively as People could start to pick up more coverage as their market capitalization expands. Macquarie recently initiated coverage (June 2017).

Back to acquisitions for a moment – we believe that People is specifically well positioned to continue acquiring regional TPA players, and according to management we believe there are roughly 12 of them to choose from. These TPA’s will move the needle in a big way for People and we believe it is realistic that they will pick a couple of these off in the next few years.
From a balance sheet perspective Peoples debt capacity has been increased tremendously over the years, with total credit availability at ~$76mm. Our best estimate pegs total balance available at ~$35m with an additional $10m in cash. If People used their current liquidity for acquisitions we believe that the shares could rise +20% in the short term. Given their current valuation of approximately 12.6x EBITDA, they can create a lot of value by purchasing businesses in the 5-6x EBITDA range. See example below:

Based on past deals we believe they can execute 2-3 transactions to get to a price tag of $45m. This could be achieved as fast as 1 year, but likely over 2-3 years. We would not rule out larger acquisitions or the use of equity, both of which could significantly add to shareholder returns. While our simplistic analysis above keeps the type of deal generic we believe the market would ascribe even higher value for TPA deals versus brokerage. Below are some details from their last acquisitions.

Review of Recent Acquisitions

Each of the following acquisitions closed in the last 2 years and followed a similar framework.

Sirius Benefit Plans Inc

Sirius Benefit Plans Inc. provides third party administration services. The company was incorporated in 1996 and is based in Winnipeg, Canada.

• People Corp. acquired Sirius Benefit Plans Inc. on April 12, 2017 for total consideration of$15mm.• People Corp. acquired Sirius Benefit Plans Inc. on April 12, 2017 for total consideration of$15mm.

• People Corp. acquired 100% of the shares, of which $13.5mm will be funded upon closing through the company’s senior credit facility, with the remaining $1.5mm to be paid in equal, $750k installments, on the 1st and 2nd anniversary of the closing.

BPA Financial Group Ltd.

Benefit Plan Administrators Limited operates a benefits administration and consulting company. It offers third party administration services for employee benefits, pension, and other plans. The company also provides consulting services, such as advice on plan design, competitive analysis, financial analysis, new product development, etc. The company was founded in 1958 and is based in Mississauga, Canada.

• BPA Financial Group Ltd. was acquired on April 13, 2016 for a total consideration of$18.8mm.

• BPA Financial Group Ltd. was acquired on April 13, 2016 for a total consideration of$18.8mm.

• People Corp. acquired 100% of the voting shares and 67% economic interest in BPA.• BPA principals have an option to retain a 33% economic interest in BPA through the ownership of non-voting, non cumulative, subordinate, dividend bearing shares of BPA. Options have a 4.5 year vesting period.

• $18.3mm was paid on closing using People Corp’s acquisition line and the remaining$0.5mm will be paid using the company’s cash on April 13, 2018.

Coughlin & Associates Ltd.

Coughlin & Associates Ltd. provides benefits consulting and administration services to Companies, unions, and public service organizations in Canada, including competitive analyses of group benefits and pension plans, managing the development and introduction of benefits programs to employees or members; and establishing plan governance criteria to ensure the conformity of administrative practices. Furthermore, it designs and administers group medical, dental, disability, life insurance, pension, and other benefits. The company was founded in 1958 and is based in Ottawa, Canada. 

• Coughlin & Associates was acquired on June 12, 2015 for total consideration of

• Coughlin & Associates was acquired on June 12, 2015 for total consideration of$30.23mm.

• People Corp. acquired a 66% interest. Principals of Coughlin & Associates retained a 34%minority interest through a class of non-voting, non-cumulative, dividend bearing shares of Coughlin.

• With the issuance of additional options, the principals of Coughlin & associates have the ability to increase their stake in Coughlin & Associates Ltd. to 40%. This would reduce People Corp. stake in Coughlin & Associates to 60%

Organic Growth

Over the last 5 years, management has grown revenues by an impressive 250% ($27mm to $94mm). This includes average organic growth of over 11% per quarter. Even more impressive is their profitability which has seen their EBITDA increase by 610% ($2.5mm to $17.8mm). This has all occurred through minimal dilution and the maintenance of a healthy balance sheet which is primed and positioned for further growth.

Fundamentals

As mentioned of the top, People was flagged in our model as a potential addition based on its value and momentum characteristics. Starting with the momentum side you can see that People has a very nice long-term trend. The ACE Fund finds its best opportunities when there is a long-term trend in place rather than a short-term spike in momentum. People is also trading above its 200-day moving average (red line) which we monitor closely for trend.

While the valuation is not cheap at these levels (12.6x NTM EBITDA) the revenue and price momentum profile captured our attention through the ACE Fund model. Upon a deeper dive into the business it’s clear that earnings and return on capital metrics will also begin to expand which should support the valuation multiple going forward.

Valuation

Valuing a company employing a roll-up strategy such as this requires more finesse than a simple historical or peer relative comparative analysis. After evaluating potential targets and market share we favor the approach of making simple assumptions about the number of deals People will execute over the next few years. We then add on an assumption regarding organic growth and then discount that back to the present. If we make some conservative assumptions you can there is a very attractive return profile.

To generate the 45% return in the model above we need to see People continue to acquire businesses at a clip of 1-2 per year, a goal which we believe is very achievable. We also need to see People expand margins by 50bps per year, which we believe is conservative and we also need to see organic growth come in at 9% per year which is lower than the last 12-month average of around 11%. In addition, as we talked about in the acquisitions section above, we assume that People eventually purchases all the EBITDA from minority owners in previous transactions.

Conclusion

In a market where roll-up strategies have been rewarded and supported for many years we have found that the potential upside in the highest quality companies deploying this strategy has diminished. Part of this has to do with current valuations baking in expected deal flow and part has to do to with the challenge of having do increasingly larger deals to move the needle. In this type of environment People really stands out as an excellent investment opportunity. They still have significant runway in the form of acquisitions, are sporting a reasonable valuation with a superb organic growth profile and are still relatively unknown by both institutional investors and analysts. From time to time we stumble upon a name such as People in our research process and we can see a path towards becoming a much larger presence on the TSX and in retail/institutional portfolio. Some of our best ideas over our investing career have come from names such as this and we believe that the risk/reward is very favourable as we see what Laurie and his team at People can do with the platform they have built until the time comes that this business is purchased by a strategic player like a large international Life insurance company wanting to establish a significant base of reference in the Canadian marketplace via owning such established customer relationships with small and mid-sized companies’ HR departments.