A Diamond in the Rough: Omega Flex and Insperity
In this analysis, I used a mutli-layered approach to scan the Russell 2000 index for examples of strong economic moats. After producing a shortlist of 20 companies, I selected two to analyze, Omega Flex and Insperity, which are the subject of this report.
This analysis marks my first deep dive into small capitalization stocks, and my first attempt at using quantitative data to screen an index for companies exhibiting signs of possessing an economic moat. With firsts all around, I had a great time doing this analysis and learned a ton along the way!
The screening methodology I used is based off of Pat Dorsey's The Little Book That Builds Wealth, which I highly recommend you check out if you haven't done so already, as it is more than worth the time investment.
You can find my summary video at the link below, with a pdf version of the full research report and analysis documents attached as well. Thanks for reading!
Analysis Summary - https://youtu.be/9LjS6HVJCAM
In this analysis, the Russell 2000 index was scanned for companies exhibiting strong evidence of possessing an economic moat. After using ROA, ROE, and net margin to filter out a short list of 20 companies, two were selected for analysis, Omega Flex, Inc. (OFLX) and Insperity, Inc. (NSP).
Omega Flex is a manufacturer of corrugated flexible metal tubing and possesses a wide economic moat driven by its extensive and meticulously maintained patent library and proprietary low-cost manufacturing process. The stock is currently underpriced in the market relative to its intrinsic value by over 15%, meaning there is a significant enough margin of safety to make the stock an attractive investment opportunity.
Insperity is a professional employer organization (PEO) providing human resource management services to small and medium-sized businesses in the US. The company does possess an economic moat arising from its heavy integration into its clients’ daily operations and the associated switching costs; however, the strength of this moat is in question. Furthermore, the company has a volatile financial history, slim operating margins, and is overleveraged. While Insperity could still be an attractive investment despite these factors, it is currently overpriced in the market and thus is not an attractive investment opportunity.
The sections below include an outline of the filters used and a complete research report and moat analysis for both companies. Unfortunately, reliable standardized financial data could only be sourced for roughly half of the Russell 2000 index, which included standardized annual income, cash flow, and balance sheet data from 2016 to 2020. This data was used in the first stage of this analysis, with all following stages drawing financial data directly from corporate fillings. All numerical values are in USD.
Finding and Analyzing Moats
Companies that may possess an economic moat can be screened quantitatively, as they will have produced consistently strong historical returns on capital and operating margins. This analysis used return-on-equity (ROE), return-on-assets (ROA), net margin and financial leverage as screeners. However, even exceptional performance on all these metrics does not guarantee that a moat is present, and thus they were used as only the first in a three-stage approach.
In the first stage, as referenced above, companies whose annual ROE, ROA, and net margins had not exceeded 15%, 7%, and 0%, respectively, in each of the last 5 years were excluded. This narrowed down an initial dataset of over 1000 companies to 20.
In the second stage, a qualitative investigation was conducted on each of these companies with two goals in mind. The first was to come to a fundamental understanding of the company’s operations, industry, and corporate structure, while the second was to determine if an economic moat did exist, its strength and durability, and what forces were driving its continuation.
Following the completion of the second stage, two companies were selected for analysis, which involved a deep dive into each company’s financial history, competitive positioning, and a discounted cash flow valuation to approximate intrinsic value. A report of this analysis is included below in the form of an investment recommendation, along with access to all relevant documents.
Lastly, this screening method is restrictive in its first stage, and likely misses a number of other companies that may have economic moats. This study is a first pass at proactively searching for and identifying moats and is not an exhaustive screen for all types and examples of them; additional studies in the future, conducted on a routine basis, would be required to achieve this level of coverage.
Omega Flex Corp. (NASDAQ: OFLX)
Omega Flex is a manufacturer of corrugated stainless-steel tubing (CSST), corrugated copper tubing (CCT), and associated fittings and accessories. The company’s products are used in natural gas, propane, petroleum, diesel exhaust fluid (DEF), and medical gas systems, primarily in the construction, healthcare, and automotive sectors. The company is a market leader in North America, which accounts for 93% of sales, while also operating in a limited capacity in the United Kingdom, European Union, and other territories, comprising the remaining 7% of sales.
Omega Flex has 170 employees and two manufacturing facilities in Exton, PA and Banbury, UK. The company mainly sells to distributors, wholesalers, and original equipment manufacturers (OEMs), largely without long-term contracts and with limited internal sales capacity for direct and e-commerce sales. This is a common practice among its peers and allows the company to quickly modulate prices to accommodate rising input costs, a benefit which has proven valuable in the current inflationary climate. Rising commodity prices, particularly in stainless steel, copper, and polyethylene, with are key inputs for manufacturing flexible metal tubing, have placed downwards pressure on operating margins at an industry-wide level. However, the company has been able to pass along these costs to their customers, with gross profit margins holding steady at 63.3% in the first quarter of 2022 compared to a year prior and exceeding those of 2020, despite revenue being on track to fall short of its peak in 2021 on the back of a declining construction market.
The CSST and CCT markets are concentrated in North America, largely divided between 10 competitors, of which the top 5 (which includes Omega Flex) control roughly 40% of the market. Several of these firms are public or operating segments of public companies, while a notable number are private. No firm has a significant leading market share, with most firms specializing in one or two use cases. This is due to several forces which act as barriers to entry for new market entrants or expanding incumbents:
1) Due to the significant capital investments needed to build new manufacturing plants, achieving economies of scale is a difficult task and a significant uphill battle against incumbent firms,
2) The design specifications across use cases (DEF, natural gas piping, etc.) vary significantly and have some but limited manufacturing process overlap. As such, additional capital investment is required for each new product line,
3) There are stringent regulatory guidelines in place for CSST and CCT products to ensure consistent quality and safety, which are also case-specific and add certification costs on top of research & development, patent protections, and capital investment,
4) Revenues in the market are “sticky.” Construction firms and contractors will often use the same brand of metal tubing in all their projects and develop a degree of brand loyalty, with price often but not always being the dominant consideration in purchase decisions,
Additionally, both markets are cyclical due to the reliance on construction demand for revenues in these markets, with demand tightening alongside decreased construction activity during the winter months. Similarly, the residential construction boom of 2021 spurred by the Covid-19 pandemic significantly increased revenues and earnings for the company, which rose 23% and 30% over the previous year, respectively. However, demand for residential construction is now waning from these highs, with the housing market entering recessionary territory after several months of significant declines in new home sales, activity from prospective buyers, and market sentiment. New housing starts are projected to shrink from 1.6 million in 2021 to 1.4 million in 2022 and then further to 1.3 million in 2023 in the US, with the Canadian housing market following suit, declining from 271k in 2021 to 223k in 2024. This is mainly being driven by rising interest rates to combat stubbornly high inflation, both of which are likely to remain elevated for several years, putting downwards pressure on both the supply and demand side by increasing material and labour costs while also reducing the accessibility of financing for homebuyers.
However, when inflation and interest rates eventually decline from their historic highs, general construction and, most importantly, residential starts will rebound. There is still a significant housing deficit of between 3.5 and 3.8 million units in the US and up to 3.9 million units in Canada (when looking to restore affordability), with general population growth providing a strong macroeconomic tailwind to the industry. As such, the outlook for both the CSST and CCT markets over the long term is strong, fueled by long-term demand for these products for new construction and renovations across the residential, commercial, and industrial sectors. The CSST market, which includes tubing, fittings, safety and grounding devices, and accessories, is projected to grow at a compounded 4.6% annual rate into 2030, with the medical equipment CCT market projected to grow at a similar 4.5% compounded rate.
Omega Flex’s economic moat arises from its intangible assets, primarily its extensive and continually developing patent library, while the company’s proprietary rotary manufacturing process, a trade secret, also plays a role. This moat shows significant signs of strength and durability and is likely to remain strong over the long term.
The company currently holds 247 patents in the US, Canadian, and European markets, covering nearly all its product offerings and applications. Critically, the company has a strong history of innovation and replacing expiring patents, with 30 new patents being approved in 2021 alone and the number of patents growing modestly over the last decade. Furthermore, these patents are being commercialized, with Omega Flex launching several new product lines over the last decade to complement its TracPipe, CounterStrike and DoubleTrac lines, which have traditionally been the backbone of its offerings.
In 2011, the company introduced its DEF-Trac tubing into the automotive industry, which is used in diesel-fueled vehicles to transport diesel exhaust fluid (DEF) from storage tanks into the catalytic converter. DEF breaks down many harmful byproducts of diesel combustion and is required by federal law in the US; however, it is highly corrosive and freezes at only -11 C, as it is around two-thirds water, and must be heated in colder climates, all which DEF-Trac was designed to handle.
In 2014, the company introduced AutoSnap, a line of metal-on-metal sealed fittings for use with its CSST products, and allows for more efficient installment of the company’s products. AutoSnap has since grown to represent the majority of the company’s fittings revenue.
In 2019, Omega Flex brought its MediTrac CCT product line to market after beta site testing in 2018. The system later gained full regulatory approval for installation in all medical facilities in the US in 2020, coinciding with increased demand brought on by the Covid-19 pandemic which helped rapidly increase adoption of the system. MediTrac is used to transport oxygen, nitrogen, nitrous oxide, carbon dioxide gas and provide medical vacuum, and is both antibacterial and fitted with a fire-retardant jacket. Since MediTrac is flexible, unlike the traditional copper piping used in healthcare facilities, it can be installed far easier and in one-fifth the time, according to a case study, as installation requires no welding and far fewer joints thanks to the product’s associated fitting lineup. This also makes the system safer in the long run relative to rigid copper piping, reducing the number of weak points where contamination can occur.
Lastly, on this note, the company also has patents pending for their AutoFlare fittings, CounterStrike polyethylene conductive jacket, and specialized MediTrac fittings. These new product lines and associated patents have been driven by consistent R&D investment, which rose to 3.9% of sales for the first quarter of 2022, up from a median of 3.5% over the last decade and is significantly higher than its competitors, which ranged below 2% of sales.
In addition to patents, the company has also developed a proprietary manufacturing process for their flexible metal tube products measuring 2” in diameter or less, which covers most of the company’s tubing products. This process was ruled a trade secret under Pennsylvania law in 2007, and Omega Flex claims it allows them to manufacture such products at both a lower cost than any other method currently available and on a demand basis while meeting delivery deadlines, reducing inventory carrying costs. This claim appears valid, as Omega Flex’s operating margin of 63% is above those of its competitors and 1.6 times the metal fabrication industry average of 39%.
Importantly, as shown below, these competitive advantages have materialized financially, with Omega Flex maintaining a median ROE, ROA, and net margin of 46%, 28%, and 19%, respectively, over the last 5 years. Even during the pandemic, Omega Flex’s returns were strong, with ROA and net margin increasing in 2021 while ROE declined only 110 bps.
Omega Flex is an attractive investment, possessing a strong moat driven by its patents and innovative history as outlined above, and is underpriced in the market. An FCFE valuation of the company arrived at an intrinsic value of $132 per share compared to the current share price of $110, making for a large enough margin of safety (>15%). However, this position is opposed by valuation multiples, with a P/E ratio of 52x and a P/FCF ratio of 37x, which are both above their competitors and general investment targets by a fair margin.
However, given the current macroeconomic backdrop and recessionary forces at play, it may be wise to hold off temporarily as it may become possible to acquire Omega Flex’s stock at a lower price in the near future.
The FCFE model had 3 separate stages; an initial negative growth phase caused by the construction pullback, followed by a transitionary period back to stable long-run growth. In the slowdown phase, a 4.2% annual decline in earnings until 2024 as used, which was calculated using the forecasted number of new residential housing starts in the US. In the transitionary period, growth gradually rebounded to the CSST industry average of 4.5% per annum before increasing further to around 5.1% annually for the perpetual growth rate, which was calculated using the CAGR in earnings over the last 5 years excluding the one-time impact of the Covid-19 pandemic on earnings in 2021. A sensitivity analysis was conducted on the slowdown and perpetual growth rates, which may be viewed in the primary analysis document included below.
In 2021, Omega Flex had annual sales of $130m with net income of $26.1m, with operations generating $24.6m of free cash flow. A summary table of Omega Flex’s key financials is included below, along with access to the primary financial model.
Insperity, Inc. (NYSE: NSP)
Insperity Inc. is a professional employer organization (PEO) and provides human resource management services and other business solutions to small and medium-sized businesses (SMBs) in the United States. The company provides tiered service packages in addition to a la carte offerings, utilizing a network of 68 physical sales locations and 3,600 employees. In 2021, the company managed payroll for 269k employees on behalf of their clients, referred to as worksite employees (WSEs) in the industry.
As a PEO, Insperity negotiates and enters into a Client Service Agreement (CSA) with their clients, which outlines the “co-employment” relationship, the responsibilities and liabilities each party assumes, and fees charged. Broadly, this division of responsibilities is as follows:
1) Insperity becomes the official employer of record for the WSEs, filing all necessary documents on behalf of the client with the IRS. The company is liable for the payroll, payroll taxes, Insperity-sponsored benefit plans and workers’ compensation costs for all WSEs of their clients,
2) The client continues to control its day-to-day operations and direct its employees. The client must transfer its payable wages and related to Insperity to be distributed,
3) Both parties share responsibility for internal compliance with applicable regulations,
The PEO industry in the U.S. is relatively new, having arisen in the late 20th century because of the increasing complexity of government regulations and resulting administrative strain. The industry primarily serves SMBs, who are often too small to have their own HR departments and could reduce overall costs by outsourcing such tasks.
Despite its youth, the industry has been on a consistent trend of consolidation. Currently, there are 487 PEOs in the US, down from almost one thousand in 2016, with the top 5 managing payrolls for 43% of all WSEs, that being Advanced Data Processing (ADP), Paychex (PAYX), Insperity (NSP), the TriNet Group (TNET), and Barrett Business Services (BBSI), in that order. An outline of key industry statistics over time is included in the table below.
This consolidation has come alongside steady industry growth, with the number of WSEs and gross industry revenue increasing 7.6% and 6.7% annually, respectively, from 2008 to 2020, despite recent declines in the number of businesses served. This growth is cyclical, however, with the introduction of new regulations for SMBs being the key driver during years of elevated growth, which have ranged between 5.5% and 21.1% from 2008 to 2020, while years without any significant regulatory changes averaged a far slower growth rate of only 1.5%.
However, new regulations are constantly being added, and existing ones are routinely modified, with an average of 3,000 new regulations enacted at the federal level each year. The per-employee cost of adhering to these regulations is far higher for SMBs compared to larger businesses by an additional 29% to 152%, depending on the industry, which is a major benefit of PEOs, as they allow businesses to save money and operate more efficiently by spreading out costs and centralizing regulatory knowledge. This is evident when comparing their performance to similar companies that don’t use a PEO; during the Covid-19 pandemic, for example, businesses using PEO were 58% less likely to have permanently closed and 32% less likely to have seen a net negative overall effect on their operations. Additionally, PEO clients as a class increased their employee count by 1% from January 2020 to June 2021, compared to a 6% decline for comparable businesses. This is partly due to the cost savings achieved by clients of PEOs, which allowed them to offer more competitive compensation packages to their employees compared to their competitors, an asset in the highly competitive labour markets of late. These factors represent the primary value propositions of the PEO industry and will almost certainly persist into the future, and there remains considerable room for growth, as only a fraction of small businesses currently use a PEO. As such, the historic levels of growth in the PEO industry will likely persist for the foreseeable future.
Interestingly, despite the industry’s rapid growth, only 42 US states have a defined legal framework for PEOs, which generally focus on the co-employment relationship. However, as part of the Tax Increase Prevention Act of 2014, the Small Business Efficiency Act (SBEA) created a voluntary certification program with the IRS for PEOs, which grants these Certified PEOs (CPEOs) clear statutory authority to collect and remit federal employment taxes on behalf of their clients while also providing federal tax credits. Most PEOs in the US are CPEOs, including Insperity, as the benefits granted by the certification process make it a de-facto necessity to compete.
Insperity’s economic moat arises from the high degree of integration into its clients’ daily operations and the associated switching costs. Compounded by the customized nature of many of Insperity’s higher-tier offerings, to switch to another PEO, Insperity’s clients would have to pay out of pocket to have the competitor’s system set up and their staff trained in its use while also risking downtime in service to their customers in the process. This makes switching difficult to justify, especially for SMBs who lack the resources of larger firms, unless there is a necessary niche service provided only by the competitor or a significantly lower service fee, neither of which appear to exist in the industry as all major firms offer an identical suite of services at similar prices.
However, the economic value of this moat, while evident in some measures, it not in others. Insperity has an extremely high ROE of 461%, a new peak after nearly a decade of continual annual improvement. However, this excludes 2021 and 2019, when ROE was deeply negative due to negative book value, which is discussed below. Additionally, ROA has trended downwards in recent history, the opposite of ROE, from a high of 11% in 2018 to 5.5% for the first half of 2022, which makes declaring Insperity’s moat as “wide” a tough claim to back up.
Furthermore, ROE may be misleading, as the company’s substantial debt obligations, which are discussed below, provide a significant boost. Adding back debt to equity causes current ROE to drop drastically to just 26% and the 5-year median to drop to 49%, which, while still impressive, are far lower. Furthermore, this action reverses the growth trend in ROE, which now has declined by 57% over the last 5 years. This phenomenon was spurred in 2016, the year Insperity went from having no outstanding debt to over $100m, in which ROE jumped from 24% to 136% while ROA only increased to 7.1% from just 4.9%. While adding back all of the company’s debt is hardly a proper
Lastly, while Insperity’s moat defends the company’s existing and incoming clientele, which is extensive given its 3rd position market share, it does little to provide an advantage in acquiring new clients who have just entered the PEO industry. The predominant competitive avenues for acquiring new customers in the industry are price and degree of service, on which there is stiff competition and no sustainable competitive advantage, thus blunting the impact of this moat, making it narrow at best.
Insperity is not an attractive investment for several reasons despite its moat, although a decisive recommendation is difficult to make. Firstly, shareholder’s equity has declined drastically over the last decade. As discussed in the Moat Analysis section above, Insperity had negative shareholder’s equity less goodwill in both 2021 and 2019, which were the result of several factors, including slower revenue growth (16% in 2021 and 13% in 2019) compared to growth in accrued WSE wages and payroll taxes (26% in 2021 and 189% in 2019) and increased outstanding debt. These instances are not outliers, however, but rather the culmination of a long-term trend. Since 2013, liabilities growth has outpaced that of assets nearly every year, leading to a 90% decline in equity. While the earnings and cash flow results achieved during the last decade are difficult to argue against, the atypical apparent trade-off between growth and shareholder equity, extended out into the future, is a worrying sign, even when considering Insperity’s high interest coverage of 32x.
This ties directly into the second issue: Insperity’s thin net margins and little financial cushioning. Insperity’s net margin of just 3.4% is low, both in an absolute sense and relative to its competitors, with the ADP TotalSource operating segment yielding 9.8%, the Paychex PEO operating segment at 30.2%, the TriNet Group at 7.5%, and Barrett Business Services at 3.8%. While net margins have improved greatly since 2013, up from just 1.4%, they have now returned to pre-pandemic levels, which had seen improvement plateau in the 3.2% and 3.5% range. Combined with the company’s low current ratio of just 1.1x, a product of its ever-increasing accrued WSE payroll expenses, Insperity’s financial strength is in question. This point is further supported by the company’s heavy D/E ratio of 1,647%, corresponding to $369m in outstanding debt on a $650m revolving-credit facility. That said, Insperity’s interest coverage ratio of 32x, alongside a maturity date in June 2027 with the ability to refinance, which Insperity did earlier this year to add $150m to the credit line and push back the maturity from September 2022, does reduce concerns on this front somewhat.
Lastly, while an FCFE valuation of $133 compared to a current share price of $112 signals the company is underpriced in the market, this view is somewhat countered by current valuation multiples. As of August 2022, Insperity has an annualized P/FCF ratio of 38x and a P/E multiple of 29x, both of which are above investment targets. Compared to Insperity’s peers, who average a P/FCF of 26x and a P/E of 31x, Insperity’s stock may or may not be slightly under or overvalued. As such, given the financial issues outlined above, alongside a present but weak economic moat, Insperity is not currently an attractive investment relative to other known opportunities.
In 2021, Insperity had annual sales of $4.97B with net income of $69.8m, generating $74.0m of free cash flow. A summary table of Insperity’s key financials is included below, along with access to the primary financial model.