10-Q


 
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
 
FORM 10-Q
 
(Mark One)
x
QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
For the quarterly period ended September 30, 2015
o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Commission File Number: 001-36373
 
TriNet Group, Inc.
(Exact Name of Registrant as Specified in its Charter)
 
Delaware
 
95-3359658
(State or other jurisdiction of
incorporation or organization)
 
(I.R.S. Employer
Identification No.)
1100 San Leandro Blvd., Suite 400
San Leandro, CA 94577
(Address of principal executive offices) (Zip code)
Registrant’s telephone number, including area code: (510) 352-5000
 
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No  o
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§ 232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).    Yes  x    No  o
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See the definitions of “large accelerated filer,” “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.
Large accelerated filer
o
Accelerated filer
o
 
 
 
 
Non-accelerated filer
x (do not check if a smaller reporting company)
Smaller reporting company
o
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).    Yes  o    No  x
As of October 31, 2015, the registrant had 70,022,338 shares of common stock outstanding.
 



TABLE OF CONTENTS
 
 
Page
PART I.
FINANCIAL INFORMATION
 
Item 1.
 
 
 
 
 
Item 2.
Item 3.
Item 4.
PART II.
OTHER INFORMATION
 
Item 1.
Item 1A.
Item 2.
Item 3.
Item 4.
Item 5.
Item 6.




PART I — FINANCIAL INFORMATION

Item 1. Financial Statements

TriNet Group, Inc. and Subsidiaries
CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share data)
(Unaudited)
 
September 30,
2015
 
December 31,
2014
Assets
 
 
 
Current assets:
 
 
 
Cash and cash equivalents
$
146,315

 
$
134,341

Restricted cash
14,554

 
14,543

Prepaid income taxes
21,071

 
26,711

Prepaid expenses
12,794

 
9,336

Deferred loan costs and other current assets
4,014

 
4,271

Worksite employee related assets
867,126

 
1,635,136

Total current assets
1,065,874

 
1,824,338

Workers compensation receivable
28,974

 
31,905

Restricted cash and investments
104,348

 
69,447

Property and equipment, net
36,352

 
32,298

Goodwill
290,507

 
288,857

Other intangible assets, net
52,534

 
81,718

Deferred and other long term income taxes
21,705

 
7,184

Deferred loan costs and other assets
9,277

 
12,017

Total assets
$
1,609,571

 
$
2,347,764

Liabilities and stockholders’ deficit
 

 
 

Current liabilities:
 

 
 

Accounts payable
$
14,863

 
$
12,273

Accrued corporate wages
34,559

 
29,179

Deferred income taxes
69,228

 
65,713

Current portion of notes payable and borrowings under capital leases
20,274

 
20,738

Other current liabilities
10,537

 
10,303

Worksite employee related liabilities
862,003

 
1,630,555

Total current liabilities
1,011,464

 
1,768,761

Notes payable and borrowings under capital leases, less current portion
484,484

 
524,412

Workers compensation liabilities
121,028

 
75,448

Other liabilities
6,694

 
4,902

Total liabilities
1,623,670

 
2,373,523

Commitments and contingencies (Note 11)


 


Stockholders’ deficit:
 

 
 

Preferred stock, $.000025 per share stated value; 20,000,000 shares authorized;
   no shares issued and outstanding at September 30, 2015 and December 31, 2014
—

 
—

Common stock, $.000025 per share stated value; 750,000,000 shares authorized;
   69,989,672 and 69,811,326 shares issued and outstanding at September 30, 2015
   and December 31, 2014, respectively
485,873

 
442,682

Accumulated deficit
(499,467
)
 
(468,127
)
Accumulated other comprehensive loss
(505
)
 
(314
)
Total stockholders’ deficit
(14,099
)
 
(25,759
)
Total liabilities and stockholders’ deficit
$
1,609,571

 
$
2,347,764

See accompanying notes.

3


TriNet Group, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except share and per share data)
(Unaudited)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Professional service revenues
$
99,473

 
$
86,864

 
$
294,288

 
$
251,999

Insurance service revenues
568,535

 
469,087

 
1,639,305

 
1,337,870

Total revenues
668,008

 
555,951

 
1,933,593

 
1,589,869

Costs and operating expenses:
 

 
 
 
 

 
 

Insurance costs
534,481

 
428,184

 
1,535,678

 
1,209,536

Cost of providing services (exclusive of depreciation and
   amortization of intangible assets)
37,540

 
32,575

 
111,582

 
100,252

Sales and marketing
44,997

 
37,396

 
123,740

 
104,225

General and administrative
17,726

 
13,766

 
48,991

 
40,785

Systems development and programming costs
6,991

 
6,776

 
21,849

 
19,235

Amortization of intangible assets
10,459

 
12,743

 
32,284

 
39,559

Depreciation
4,132

 
3,265

 
10,761

 
9,725

Total costs and operating expenses
656,326

 
534,705

 
1,884,885

 
1,523,317

Operating income
11,682

 
21,246

 
48,708

 
66,552

Other income (expense):
 

 
 
 
 

 
 

Interest expense and bank fees
(4,685
)
 
(18,462
)
 
(14,653
)
 
(49,174
)
Other, net
355

 
179

 
873

 
257

Income before provision for income taxes
7,352

 
2,963

 
34,928

 
17,635

Provision for income taxes
4,255

 
2,238

 
17,328

 
9,149

Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Net income per share:
 

 
 
 
 

 
 

Basic
$
0.04

 
$
0.01

 
$
0.25

 
$
0.13

Diluted
$
0.04

 
$
0.01

 
$
0.24

 
$
0.13

Weighted average shares:
 

 
 
 
 

 
 

Basic
70,237,737

 
69,134,908

 
70,247,035

 
51,654,608

Diluted
72,087,917

 
72,954,352

 
72,757,277

 
55,003,651

 
See accompanying notes.

4


TriNet Group, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF COMPREHENSIVE INCOME
(In thousands)
(Unaudited)
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Other comprehensive income (loss), net of tax
 

 
 

 
 

 
 

Unrealized gains on investments
11

 
(10
)
 
48

 
10

Foreign currency translation adjustments
(130
)
 
(63
)
 
(239
)
 
(62
)
Total other comprehensive loss, net of tax
(119
)
 
(73
)
 
(191
)
 
(52
)
Comprehensive income
$
2,978

 
$
652

 
$
17,409

 
$
8,434

 
See accompanying notes.

5


TriNet Group, Inc. and Subsidiaries
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
(Unaudited)
 
Nine Months Ended September 30,
 
2015
 
2014
Operating activities
 
Net income
$
17,600

 
$
8,486

Adjustments to reconcile net income to net cash provided by operating activities:
 
 
 
Depreciation and amortization
42,559

 
67,754

Deferred income taxes
1,835

 
27,180

Stock-based compensation
12,991

 
8,251

Excess tax benefit from equity incentive plan activity
(20,327
)
 
—

Accretion of workers compensation and leases fair value adjustment
(523
)
 
(969
)
Changes in operating assets and liabilities:
 
 
 
Restricted cash and investments
(21,198
)
 
(7,968
)
Prepaid expenses and other current assets
(3,201
)
 
(7,899
)
Workers compensation receivables
3,294

 
(11,775
)
Other assets
(14,585
)
 
8,166

Accounts payable
2,522

 
4,826

Prepaid income taxes
27,574

 
(29,642
)
Other current liabilities
9,103

 
11,321

Other liabilities
47,419

 
22,196

Worksite employee related assets
768,010

 
75,390

Worksite employee related liabilities
(768,552
)
 
(76,921
)
Net cash provided by operating activities
104,521

 
98,396

Investing activities
 
 
 
Acquisitions of businesses
(4,750
)
 
—

Purchase of debt securities
(14,989
)
 
(16,789
)
Proceeds from maturity of debt securities
1,275

 
—

Purchase of property and equipment
(14,747
)
 
(17,082
)
Net cash used in investing activities
(33,211
)
 
(33,871
)
Financing activities
 
 
 
Proceeds from issuance of common stock, net of issuance costs
—

 
218,572

Realized tax benefit of deductible IPO transaction costs
822

 
585

Proceeds from issuance of common stock on exercised options
6,464

 
1,146

Proceeds from issuance of common stock on employee stock purchase plan
2,723

 
—

Excess tax benefit from equity incentive plan activity
20,327

 
—

Repayment of notes payable
(40,249
)
 
(268,425
)
Payment of debt issuance costs
—

 
(11,060
)
Repayments under capital leases
(244
)
 
(263
)
Repurchase of common stock
(48,940
)
 
(1,422
)
Net cash used in financing activities
(59,097
)
 
(60,867
)
Effect of exchange rate changes on cash and cash equivalents
(239
)
 
(62
)
Net increase in cash and cash equivalents
11,974

 
3,596

Cash and cash equivalents at beginning of period
134,341

 
94,356

Cash and cash equivalents at end of period
$
146,315

 
$
97,952

 
 
 
 
Supplemental disclosures of cash flow information
 
 
 
Cash paid for interest
$
11,378

 
$
25,662

Cash paid for income taxes, net
1,467

 
10,969

Supplemental schedule of noncash investing and financing activities
 
 
 
Payable for purchase of property and equipment
68

 
826

See accompanying notes.

6


TriNet Group, Inc. and Subsidiaries
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)
 
NOTE 1. DESCRIPTION OF BUSINESS AND SIGNIFICANT ACCOUNTING POLICIES
Description of Business
TriNet Group, Inc. (the Company or TriNet), a Delaware corporation incorporated in January 2000, provides a comprehensive human resources solution for small to medium-sized businesses. The Company’s solution includes payroll processing, human capital consulting, employment law compliance and employee benefits, including health insurance, retirement plans and workers compensation insurance.
The Company provides its services through co-employment relationships with its customers, under which the Company and its customers each take responsibility for certain portions of the employer-employee relationship for worksite employees (WSEs). The Company is the employer of record for most administrative and regulatory purposes, including the following: (i) compensation through wages and salaries; (ii) employer payroll-related taxes payment; (iii) employee payroll-related taxes withholding and payment; (iv) employee benefit programs including health and life insurance, and others; and (v) workers compensation coverage.
Segment Information
The Company operates in one reportable segment in accordance with Accounting Standard Codification (ASC) 280 – Segment Reporting, issued by the Financial Accounting Standards Board (FASB). All of the Company’s service revenues are generated from external customers. Less than 1% of revenues is generated outside of the United States of America (U.S.). Substantially all of the Company’s long-lived assets are located in the U.S.
Basis of Presentation
The accompanying unaudited consolidated financial statements and footnotes thereto of the Company and its wholly owned subsidiaries have been prepared in accordance with U.S. generally accepted accounting principles (GAAP) and applicable rules and regulations of the Securities and Exchange Commission (SEC) regarding interim financial reporting. Certain information and note disclosures normally included in the financial statements prepared in accordance with GAAP have been condensed or omitted pursuant to such rules and regulations. Therefore, these consolidated financial statements should be read in conjunction with the consolidated financial statements and notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 30, 2015. There have been no changes to the Company’s significant accounting policies described in such Annual Report that have had a material impact on its consolidated financial statements and related notes. All intercompany accounts and transactions have been eliminated in consolidation.
The accompanying unaudited consolidated balance sheets present the current assets and current liabilities directly related to the processing of human resources transactions as WSE-related assets and WSE-related liabilities, respectively. WSE-related assets are comprised of cash and investments restricted for current workers compensation claim payments, payroll funds collected, accounts receivable, unbilled service revenues, and refundable or prepaid amounts related to the Company-sponsored workers compensation and health plan programs. WSE-related liabilities are comprised of customer prepayments, wages and payroll taxes accrued and payable, and liabilities related to the Company-sponsored workers compensation and health plan programs resulting from workers compensation case reserves, premium amounts due to providers for enrolled employees, and workers compensation and health reserves that are expected to be disbursed within the next 12 months.
The unaudited interim financial statements have been prepared on the same basis as the annual financial statements and, in the opinion of management, reflect all adjustments, consisting only of normal recurring adjustments, necessary for fair presentation. Certain prior period amounts in the consolidated statement of cash flows and in Note 3 have been reclassified to conform to the current presentation. The results of the nine months ended September 30, 2015 are not necessarily indicative of the results to be expected for the year ending December 31, 2015.


7


Seasonality and Insurance Variability
Historically, the Company has experienced its highest monthly addition of WSEs, as well as its highest monthly levels of client attrition, in the month of January, primarily because clients that change their payroll and benefits service providers tend to do so at the beginning of a calendar year. In addition, the Company experiences higher levels of client attrition during the fourth quarter and, to a lesser extent, during the first quarter of the calendar year, in connection with renewals of the health insurance it provides for its WSEs, in the event that such renewals result in increased premiums that it passes on to its clients. The Company has also historically experienced higher insurance claim volumes in the second and third quarters of a fiscal year than in the first and fourth quarters of a fiscal year, as WSEs typically access their health care providers more often in the second and third quarters of a fiscal year, which has negatively impacted the Company’s insurance costs in these quarters. The Company has also experienced variability on a quarterly basis in the amount of insurance costs due to the number and severity of insurance claims being unpredictable. These historical trends may change, and other seasonal trends and variability may develop that make it more difficult for the Company to manage its business.
Use of Estimates
The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. These estimates include, but are not limited to, allowances for accounts receivable, workers compensation-related assets and liabilities, health plan assets and liabilities, recoverability of goodwill and other intangible assets, income taxes, stock-based compensation and other contingent liabilities. Such estimates are based on historical experience and on various other assumptions that Company management believes to be reasonable under the circumstances. Actual results could differ from those estimates.
Recent Accounting Pronouncements
In September 2015, the FASB issued Accounting Standards Update (ASU) 2015-16—Business Combinations, as part of its initiative to reduce complexity in accounting standards (the Simplification Initiative). The amendment eliminates the requirement to retrospectively apply adjustments made to provisional amounts recognized in a business combination. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. The Company expects to adopt this guidance in the current fiscal year. The Company does not expect this guidance to have a material effect on its consolidated financial statements.
In April 2015, the FASB issued ASU 2015-05—Intangibles—Goodwill and Other—Internal-Use Software, as part of the Simplification Initiative. The amendment provides guidance to clarify the customer’s accounting for fees paid in a cloud computing arrangement. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. The Company expects to adopt this guidance in 2016. The Company does not expect this guidance to have a material effect on its consolidated financial statements.
In April 2015, the FASB issued ASU 2015-03—Interest—Imputation of Interest, as part of its Simplification Initiative. The amendment requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted for financial statements that have not been previously issued. The Company is currently evaluating the impact that the adoption of this guidance will have on its consolidated financial statements.
In August 2014, the FASB issued ASU 2014-15—Presentation of Financial Statements—Going Concern (Subtopic 205-40), which addresses management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued. The standard will be effective for the first interim period within annual reporting periods beginning after December 15, 2016. Early adoption is permitted. The Company does not expect to adopt this guidance early and does not believe that the adoption of this guidance will have a material effect on its consolidated financial statements.
In June 2014, the FASB issued ASU 2014-12—Compensation—Stock Compensation, which requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted. The amendments may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented. The Company does not expect this guidance to have a material effect on its consolidated financial statements. The Company expects to adopt this guidance in 2016.

8


In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which will replace most existing revenue recognition guidance under GAAP. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard provides a five-step analysis of transactions to determine when and how revenue is recognized. In July 2015, the FASB deferred the effective date to annual reporting periods, and interim periods within those years, beginning after December 15, 2017. Early adoption at the original effective date of December 15, 2016 is permitted. The amendments may be applied retrospectively or as a cumulative-effect adjustment as of the date of adoption. The Company has not yet selected a method of adoption and is currently evaluating the effect that the amendments will have on the consolidated financial statements.
 
NOTE 2. WORKSITE EMPLOYEE-RELATED ASSETS AND LIABILITIES
The following schedule presents the components of the Company’s WSE-related assets and WSE-related liabilities (in thousands):
 
September 30,
2015
 
December 31,
2014
Worksite employee-related assets:
 
 
 
Restricted cash
$
80,943

 
$
64,890

Restricted investments
2,319

 
4,555

Payroll funds collected
479,368

 
1,336,994

Unbilled revenue, net of advance collections of $114,259
   and $113,190 at September 30, 2015 and December 31, 2014,
   respectively
281,100

 
203,599

Accounts receivable, net of allowance for doubtful accounts of
   $817 and $388 at September 30, 2015 and December 31, 2014,
   respectively
7,122

 
5,193

Prepaid health plan expenses
5,545

 
4,932

Refundable workers compensation premiums
2,751

 
7,975

Prepaid workers compensation expenses
4,177

 
1,256

Other payroll assets
3,801

 
5,742

Total worksite employee-related assets
$
867,126

 
$
1,635,136

Worksite employee-related liabilities:
 

 
 

Unbilled wages accrual
$
365,771

 
$
292,906

Payroll taxes payable
240,583

 
1,119,427

Health benefits payable
120,792

 
104,220

Customer prepayments
67,377

 
53,770

Workers compensation payable
38,246

 
36,778

Other payroll deductions
29,234

 
23,454

Total worksite employee-related liabilities
$
862,003

 
$
1,630,555


9


 
NOTE 3. WORKERS COMPENSATION
The Company has agreements with various insurance carriers to provide workers compensation insurance coverage for worksite employees. Insurance carriers are responsible for administrating and paying claims. The Company is responsible for reimbursing each carrier up to a deductible limit per occurrence.
The following summarizes the activities in the liability for unpaid claims and claims adjustment expenses (in thousands):
 
For the nine months ended September 30, 2015
 
For the year ended December 31, 2014
Liability for unpaid claims and claims adjustment
   at beginning of period
$
92,406

 
$
58,610

Incurred related to:
 

 
 

Current year
64,094

 
61,669

Prior years
3,824

 
(4,725
)
Total incurred
67,918

 
56,944

Paid related to:
 

 
 

Current year
(11,113
)
 
(11,003
)
Prior years
(22,509
)
 
(12,145
)
Total paid
(33,622
)
 
(23,148
)
Reclassification from workers compensation receivable
5,087

 
—

Liability for unpaid claims and claims adjustment
   at end of period
131,789

 
92,406

Other premiums and collateral liabilities
27,485

 
19,820

Total workers compensation liabilities at end of
   period
$
159,274

 
$
112,226

Current portion included in worksite employee-
   related liability
38,246

 
36,778

Long term portion
$
121,028

 
$
75,448

 
Under the terms of its agreements with its workers compensation insurance carriers, the Company collects and holds premiums in restricted accounts pending claims payments by the claims administrator. As of September 30, 2015 and December 31, 2014, such restricted amounts of $37.8 million and $36.5 million, respectively, are presented as restricted cash and restricted investments within WSE-related assets in the accompanying consolidated balance sheets. In addition, at September 30, 2015 and December 31, 2014, $104.3 million and $69.4 million, respectively, are presented as restricted long-term investments.

The reclassification from workers compensation receivable resulted from the return of collateral to the Company following a negotiated amendment of the underlying contract with a carrier.

NOTE 4. BUSINESS COMBINATIONS
Periodically, as part of the Company's strategic objectives, the Company may acquire other companies or may acquire strategic technologies which may be considered an acquisition of a business.  During the three months ended September 30, 2015, the Company's strategic acquisition activity resulted in the payment of aggregate purchase consideration of approximately $4.8 million, consisting solely of cash. The allocation of the aggregate purchase consideration in the quarter resulted in intangible assets of $3.1 million and goodwill of $1.7 million. The intangible assets have a useful life of 5 years. The condensed consolidated financial statements include the operating results of strategic acquisitions considered to be a business since the respective date of the acquisition. Pro forma results of operations have not been presented as the acquisition activity is not material to the Company.

NOTE 5. PROPERTY AND EQUIPMENT, NET
Property and equipment, net, consist of the following (in thousands):
 
September 30,
2015
 
December 31,
2014
Software
$
62,342

 
$
53,349

Office equipment, including data processing equipment
19,779

 
18,550

Leasehold improvements
9,761

 
7,092

Furniture, fixtures, and equipment
6,946

 
6,450

Projects in progress
6,119

 
6,786

 
104,947

 
92,227

Accumulated depreciation
(68,595
)
 
(59,929
)
Property and equipment, net
$
36,352

 
$
32,298

 
Software and furniture, fixtures, and equipment include amounts for assets under capital leases of $0.2 million and $1.4 million at September 30, 2015 and December 31, 2014, respectively. Accumulated depreciation of these assets was de minimis and $0.9 million at September 30, 2015 and December 31, 2014, respectively. Amortization of assets held under capital leases is included with depreciation expense in the accompanying consolidated statements of operations.
Projects in progress consist primarily of software development costs. The Company capitalizes software development costs intended for internal use. The Company recognized depreciation expense for capitalized internally developed software of $3.7 million and $4.0 million for the nine months ended September 30, 2015 and 2014, respectively. Accumulated depreciation for these assets was $32.8 million and $29.4 million at September 30, 2015 and December 31, 2014, respectively. The Company periodically assesses the likelihood of unsuccessful completion of projects in progress, as well as monitoring events or changes in circumstances, which might suggest that impairment has occurred and recoverability should be evaluated. An impairment loss is recognized if the carrying amount of the asset is not recoverable and exceeds the future net cash flows expected to be generated by the asset. There was $0.4 million and $0.1 million of losses recognized on internally developed software for the nine months ended September 30, 2015 and September 30, 2014, respectively.

NOTE 6. MARKETABLE SECURITIES AND FAIR VALUE MEASUREMENTS
The Company’s noncurrent restricted cash and investments include $64.2 million of available-for-sale marketable securities and $40.1 million of cash collateral at September 30, 2015. The Company’s restricted investments within WSE-related assets include $2.3 million of certificates of deposit as of September 30, 2015. The available-for-sale marketable securities as of September 30, 2015 and December 31, 2014 consist of the following (in thousands):
 
Amortized Cost
 
Gross Unrealized Gains
 
Gross Unrealized Losses
 
Estimated Fair Value
September 30, 2015:
 
 
 
 
 
 
 
U.S. treasuries
$
63,596

 
$
89

 
$
—

 
$
63,685

Mutual funds
500

 
6

 
—

 
506

Total investments
$
64,096

 
$
95

 
$
—

 
$
64,191

December 31, 2014:
 
 
 
 
 
 
 
U.S. treasuries
$
50,075

 
$
22

 
$
(15
)
 
$
50,082

Mutual funds
500

 
6

 
—

 
506

Total investments
$
50,575

 
$
28

 
$
(15
)
 
$
50,588

 
There were no realized gains or losses for the nine months ended September 30, 2015 and 2014. As of September 30, 2015 and December 31, 2014, the contractual maturities of the U.S. treasuries were two to three years.
As of September 30, 2015, none of the Company’s U.S. treasuries were in an unrealized loss position. Unrealized losses are principally due to changes in interest rates. In analyzing an issuer’s financial condition, the Company considers whether the securities are issued by the federal government or its agencies, whether downgrades by bond rating agencies have occurred, and industry analysts’ reports. The fair value of these securities in an unrealized loss position represented 0% and 59% of the total fair value of all securities available for sale as of September 30, 2015 and December 31, 2014, respectively, and their unrealized losses were de minimis as of September 30, 2015 and December 31, 2014. As the Company has the ability and intent to hold

10


debt securities until maturity, or for the foreseeable future as classified as available for sale, no decline was deemed to be other-than-temporary.
Fair value is an exit price, representing the amount that would be received to sell an asset or paid to transfer a liability in an orderly transaction between market participants. As such, fair value is a market-based measurement that should be determined based on assumptions that market participants would use in pricing an asset or a liability.
As a basis for considering such assumptions, the Company uses a three-tier value hierarchy, which prioritizes the inputs used in measuring fair value as follows:
•
Level I—observable inputs such as quoted prices in active markets
•
Level II—inputs other than the quoted prices in active markets that are observable either directly or indirectly
•
Level III—unobservable inputs in which there is little or no market data, which requires the Company to develop its own assumptions
This hierarchy requires the Company to use observable market data when available and to minimize the use of unobservable inputs when determining fair value.
The following table summarizes the Company’s financial assets measured at fair value on a recurring basis (in thousands):
 
Total
Fair Value
 
Level I
 
Level II
 
Level III
September 30, 2015:
 
 
 
 
 
 
 
Certificates of deposit
$
2,319

 
$
2,319

 
$
—

 
$
—

U.S. treasuries
63,685

 
63,685

 
—

 
—

Mutual funds
506

 
506

 
—

 
—

Total
$
66,510

 
$
66,510

 
$
—

 
$
—

December 31, 2014:
 
 
 
 
 
 
 
Certificates of deposit
$
2,318

 
$
2,318

 
$
—

 
$
—

U.S. treasuries
50,082

 
50,082

 
—

 
—

Mutual funds
506

 
506

 
—

 
—

Interest rate cap
1

 
—

 
1

 
—

Total
$
52,907

 
$
52,906

 
$
1

 
$
—

 
There were no transfers between Level I and Level II assets during the nine months ended September 30, 2015 or the year ended December 31, 2014.
As of September 30, 2015 and December 31, 2014, certificates of deposit consisted of certificates of deposit held by domestic financial institutions, which are presented as restricted investments within WSE-related assets in the accompanying consolidated balance sheets.
The carrying value of the Company’s financial instruments not measured at fair value, including cash, restricted cash, WSE-related assets and liabilities, line of credit and accrued corporate wages, approximates fair value due to the relatively short maturity, cash repayments or market interest rates of such instruments. The fair value of such financial instruments, other than cash and restricted cash, is determined using the income approach based on the present value of estimated future cash flows. The fair value of all of these instruments would be categorized as Level II of the fair value hierarchy, with the exception of cash and cash equivalents, which would be categorized as Level I.
At September 30, 2015 and December 31, 2014, the carrying value of the Company’s notes payable of $504.6 million and $544.9 million, respectively, approximated fair value. The estimated fair values of the Company’s notes payable are considered a Level II valuation in the hierarchy for fair value measurement and are based on a cash flow model discounted at market interest rates that considers the underlying risks of unsecured debt.




11


NOTE 7. NOTES PAYABLE AND BORROWINGS UNDER CAPITAL LEASES
The following schedule summarizes the components of the Company’s notes payable and borrowings under capital leases balances (in thousands):
 
September 30,
2015
 
December 31,
2014
Notes payable under credit facility
$
504,626

 
$
544,875

Capital leases
132

 
275

Less current portion
(20,274
)
 
(20,738
)
 
$
484,484

 
$
524,412

 
In March 2014, the proceeds from the Company’s initial public offering (IPO) were used to fully repay its existing $190.0 million second lien credit facility, which resulted in a prepayment premium of $3.8 million, and to repay $25.0 million of its existing first lien tranche B-1 term loan. Additionally, the remaining balance of the loan fees associated with the second lien credit facility and a portion of the loan fees associated with the first lien credit facility were fully amortized in March 2014 for a charge of $5.0 million. In May 2014, the Company repaid $25.0 million of the first lien tranche B-1 term loan. As a result, a portion of the loan fees associated with the first lien credit facility was fully amortized in May 2014 for a charge of $0.5 million.
In July 2014, the Company amended and restated its first lien credit facility pursuant to an amended and restated first lien credit agreement (the Amended and Restated Credit Agreement). The Amended and Restated Credit Agreement provides for: (i) $375 million principal amount of tranche A term loans, (ii) $200 million principal amount of tranche B term loans, and (iii) a revolving credit facility of $75 million. The proceeds of the tranche A term loans were used to refinance in part the tranche B-2 term loans outstanding under the original first lien credit facility. The proceeds of the tranche B term loans were used to (i) refinance the remaining tranche B-2 term loans outstanding under the original first lien credit facility, (ii) refinance other amounts outstanding under the original first lien credit facility and (iii) pay fees and expenses related thereto. The revolving credit facility replaced the revolving credit facility under the original first lien credit facility.
The tranche A term loans and the revolving credit facility will mature on July 9, 2019. The tranche B term loans will mature on July 9, 2017. Loans under the revolving credit facility are expected to be used for working capital and other general corporate purposes.
The tranche A term loans and loans under the revolving credit facility bear interest, at the Company’s option, at a rate equal to either the LIBOR rate, plus an applicable margin equal to 2.75% per annum, or the prime lending rate, plus an applicable margin equal to 1.75% per annum. The applicable margins for the tranche A term loans and loans under the revolving credit facility are subject to reduction by 0.25% or 0.50%, or increase by 0.25%, based upon the Company’s total leverage ratio. The tranche B term loans bear interest, at the Company’s option, at a rate equal to either the LIBOR rate, plus an applicable margin equal to 2.75% per annum or the prime lending rate, plus an applicable margin equal to 1.75% per annum. The Company is required to pay a commitment fee of 0.50%, subject to decrease to 0.375% based on its total leverage ratio, on the daily unused amount of the commitments under the revolving credit facility, as well as fronting fees and other customary fees for letters of credit issued under the revolving credit facility.
The Company is permitted to make voluntary prepayments at any time without payment of a premium. The Company is required to make mandatory prepayments of term loans (without payment of a premium) with (i) net cash proceeds from issuances of debt (other than certain permitted debt), (ii) net cash proceeds from certain non-ordinary course asset sales and casualty and condemnation proceeds (subject to reinvestment rights and other exceptions), and (iii) beginning with the fiscal year ending December 31, 2015, 50% of its excess cash flow (subject to decrease to (x) 25% if its total leverage ratio as of the last day of such fiscal year is less than 3.75 to 1.0 and equal to or greater than 3.00 to 1.0, and (y) 0% if the total leverage ratio as of the last day of such fiscal year is less than 3.00 to 1.0), provided that the Company may defer prepayments based on excess cash flow to the extent such payments would result in the working capital being less than $10 million (after giving effect to such prepayments).
The tranche A term loans will be paid in equal quarterly installments in an aggregate annual amount equal to: (i) beginning on December 31, 2014 to December 31, 2016, 5% of the original principal amount thereof, (ii) beginning on December 31, 2016 to December 31, 2018, 7.5% of the original principal amount thereof, and (iii) beginning on December 31, 2018 to June 30, 2019, 10% of the original principal amount thereof with any remaining balance payable on the final maturity date of the tranche A term loans. The tranche B term loans will be paid in equal quarterly installments in an aggregate annual

12


amount equal to 1% of the original principal amount thereof, with any remaining balance payable on the final maturity date of the tranche B term loans.
The $75.0 million revolving credit facility includes capacity for a $30.0 million letter of credit facility and a $10.0 million swingline facility. The total unused portion of the revolving credit facility was $59.5 million as of September 30, 2015. In connection with the Amended and Restated Credit Agreement, the Company incurred $11.1 million of debt issuance costs. The Company deferred $8.0 million of the costs, which are being amortized over the term of the credit facility.  The remaining $3.1 million of costs were recorded to interest expense and bank fees.  Additionally, the Company recorded a $9.0 million loss on extinguishment of debt to write-off deferred issuance costs associated with the original first lien credit facility, which was also recorded to interest expense and bank fees.  The remaining $6.1 million of loan fees associated with the previous facility that was deemed to be modified continues to be amortized over the revised remaining term of the Amended and Restated Credit Agreement.
In March 2015, the Company repaid $25.0 million of the first lien tranche B-1 term loan. As a result, a portion of the loan fees associated with the first lien credit facility was fully amortized in March 2015 for a charge of $0.4 million.
The Amended and Restated Credit Agreement contains customary representations and warranties and customary affirmative and negative covenants applicable to the Company and its subsidiaries, including, among other things, restrictions on indebtedness, liens, investments, mergers, dispositions, prepayment of other indebtedness, and dividends and other distributions. The Amended and Restated Credit Agreement also contains financial covenants that require the Company to maintain a minimum consolidated interest coverage ratio of at least 3.50 to 1.00, beginning with the fiscal quarter ending September 30, 2014, and a maximum total leverage ratio, currently at 4.50 to 1.00. The Company was in compliance with the restrictive covenants under the credit facilities at September 30, 2015. The credit facility is secured by substantially all of the Company’s assets and the assets of the borrower and of the subsidiary guarantors, other than specifically excluded assets.

NOTE 8: STOCKHOLDERS’ EQUITY
Equity-Based Incentive Plans
In 2000, the Company established the 2000 Equity Incentive Plan (the 2000 Plan), which provided for granting incentive stock options, nonstatutory stock options, bonus awards and restricted stock awards to eligible employees, directors, and consultants of the Company. In December 2009, the Board of Directors approved the 2009 Equity Incentive Plan (the 2009 Plan) as the successor to and continuation of the 2000 Plan. As of the 2009 Plan effective date, remaining shares available for issuance under the 2000 Plan were cancelled and became available for issuance under the 2009 Plan. No additional stock awards will be granted under the 2000 Plan. The 2009 Plan provides for the grant of the following awards to eligible employees, directors, and consultants: incentive stock options, nonstatutory stock options, stock appreciation rights, restricted stock awards, restricted stock unit awards, performance stock awards, performance cash awards, and other stock awards. Incentive stock options may only be granted to employees. Nonemployee directors are eligible to receive nonstatutory stock options automatically at designated intervals over their period of continuous service on the Board. The 2009 Plan, as amended, provides that the number of shares reserved for issuance under the 2009 Plan will increase on January 1 of each year for a period of up to five years by 4.5% of the total number of shares of capital stock outstanding on December 31 of the preceding calendar year, which will begin on January 1, 2015 and continue through January 1, 2019. On January 1, 2015, an additional 3,141,509 shares were automatically reserved for issuance under the amended 2009 Plan.
The exercise price per share of all incentive stock options granted under the 2000 Plan and the 2009 Plan must be at least equal to the fair market value of the shares at the date of grant as determined by the Board of Directors. Options issued to recipients other than nonemployee directors generally vest over four years with a one year cliff and monthly thereafter, and have a maximum contractual term of 10 years. Incentive stock options granted at 110% of the fair market value to stockholders who have greater than 10% ownership have a maximum term of five years.
The Company has granted restricted stock units (RSUs) to members of the Board of Directors and certain executives. These RSUs represent rights to receive shares of the Company’s common stock on satisfaction of applicable vesting conditions. The fair value of RSUs is equal to the fair value of the Company’s common stock on the date of grant. The RSUs granted to the members of the Board of Directors vest a year from the grant date. The RSUs granted to newly hired employees vest at a rate of 25% of the total RSUs a year after the grant date and then 1/16 of the total RSUs granted on the 15th day of the second month of each calendar quarter thereafter.  All other RSUs granted to employees vest at a rate of 1/16 of the total RSUs granted on the 15th day of the second month of each calendar quarter following the grant date.  
In March 2015, the Company granted performance-based restricted stock units (PSUs) to its executives intended to represent 33.3% of each executive’s annual long-term incentive compensation award value in fiscal 2015. These PSUs vest

13


over three years based on the Company’s attainment of annual financial performance goals as well as the executive’s continued employment through each vesting date. The number of shares that ultimately vest each year will range from 0 to 200% of the annual target amount, based on the Company’s performance. Cumulative financial performance metrics and goals are established for these awards at the grant date and the tranche of each award related to that period’s performance goal is treated as a separate grant for accounting purposes. The financial performance metric established for the performance awards is cumulative annual growth rate in the Company’s net service revenues. These values are being recognized over the tranches’ 12-month, 24-month and 36-month service periods. The Company began recording stock-based compensation expense for these tranches in March 2015, when the financial performance goals were established.
Equity incentive plan activity under the 2000 Plan and the 2009 Plan for the nine months ended September 30, 2015 is summarized as follows:
Equity Incentive Plan Activity
Shares Available for Grant
Balance at December 31, 2014
2,708,524

Authorized
3,141,509

Granted
(1,400,109
)
Forfeited
597,960

Expired
1,250

Shares withheld for taxes and not issued
24,852

Balance at September 30, 2015
5,073,986


The following table summarizes stock option activity under the Company’s equity-based plans for the nine months ended September 30, 2015:
Stock Options Activity
Number
of Shares
 
Weighted
Average
Exercise
Price
 
Weighted
Average
Remaining
Contractual
Term
 
Aggregate
Intrinsic
Value
(in thousands)
Balance at December 31, 2014
6,892,810

 
$
6.13

 
8.22
 
$
173,338

Granted
312,200

 
31.66

 

 


Exercised
(1,918,378
)
 
3.42

 

 


Forfeited
(575,532
)
 
7.83

 

 


Expired
(1,250
)
 
10.98

 

 


Balance at September 30, 2015
4,709,850

 
$
8.72

 
7.79
 
$
45,341

 
 
 
 
 
 
 
 
Exercisable at September 30, 2015
1,843,386

 
$
5.78

 
7.34
 
$
21,443

Vested and expected to vest at September 30, 2015
4,468,943

 
$
8.45

 
7.76
 
$
43,827

 
The weighted-average grant date fair value of stock options granted in each of the three months ended September 30, 2015 and September 30, 2014 was $8.09 and $15.83 per share, respectively.  The weighted-average grant date fair value of stock options granted in each of the nine months ended September 30, 2015 and September 30, 2014 was $12.85 and $6.99 per share, respectively.  The total fair value of options vested for the three months ended September 30, 2015 and September 30, 2014 was $1.8 million and $1.7 million, respectively. The total fair value of options vested for the nine months ended September 30, 2015 and September 30, 2014 was $7.5 million and $6.2 million, respectively.  
The total intrinsic value of options exercised for the three months ended September 30, 2015 and September 30, 2014 was $7.3 million and $6.8 million, respectively.  The total intrinsic value of options exercised for the nine months ended September 30, 2015 and September 30, 2014 was $50.3 million and $16.8 million, respectively.  Cash received from options exercised during the nine months ended September 30, 2015 and September 30, 2014 was $6.6 million and $1.1 million, respectively.  The exercise price of all options granted was equal to the fair value of the common stock on the date of grant.
As of September 30, 2015, unrecognized compensation expense, net of forfeitures, associated with nonvested options outstanding was $17.1 million and is expected to be recognized over a weighted-average period of 1.68 years.

14


The following table summarizes RSU activity under the Company’s equity-based plans for the nine months ended September 30, 2015:
Restricted Stock Unit Activity
Number of Units
 
Weighted-Average
Grant Date
Fair Value
Nonvested at December 31, 2014
7,750

 
$
13.21

Granted
914,623

 
$
30.49

Vested
(71,053
)
 
$
32.84

Forfeited
(22,428
)
 
$
33.51

Nonvested at September 30, 2015
828,892

 
$
30.05

 
The total grant date fair value of RSUs granted in the three months ended September 30, 2015 was $3.0 million. The total grant date fair value of RSUs granted in the nine months ended September 30, 2015 was $27.9 million. The total grant date fair value of RSUs vested in the three months ended September 30, 2015 was $1.2 million. The total grant date fair value of RSUs vested in the nine months ended September 30, 2015 was $2.3 million. As of September 30, 2015, unrecognized compensation expense, net of forfeitures, associated with the nonvested RSUs outstanding was $22.4 million, and is expected to be recognized over a weighted-average period of 3.31 years.
The following table summarizes PSU activity under the Company’s equity-based plans for the nine months ended September 30, 2015:
Performance Based Restricted Stock Unit Activity
Number of Units
 
Weighted-Average
Grant Date
Fair Value
Outstanding units at December 31, 2014
—

 
$
—

Granted
173,286

 
$
33.51

Units converted
—

 
$
—

Forfeited
—

 
$
—

Outstanding units at September 30, 2015
173,286

 
$
33.51

The maximum total grant date fair value of PSUs granted in the nine months ended September 30, 2015 was $5.8 million, assuming maximum 200% performance target is met.  As of September 30, 2015, unrecognized compensation expense assuming a 100% performance target is met during 2016 and 2017, net of forfeitures, was $1.3 million, and is expected to be recognized over a weighted-average period of 2.25 years.         
Employee Stock Purchase Plan
The Company adopted the 2014 Employee Stock Purchase Plan (ESPP) in February 2014, which became effective on March 26, 2014. The ESPP was approved with a reserve of 1.1 million shares of common stock for future issuance under various terms provided for in the ESPP, which will automatically increase on January 1 of each year from 2015 through 2024 by the lesser of 1% of the total number of shares outstanding on December 31 of the preceding calendar year or 1,800,000 shares. On January 1, 2015, an additional 698,113 shares were automatically reserved for issuance under the ESPP. The Company commenced its first purchase period under the ESPP on March 26, 2014 with a purchase price equal to the lesser of 85% of the fair market value of the common stock on the offering date and 85% of the fair market value of the common stock on the applicable purchase date.  Offering periods are six months in duration and will end on or about May 15 and November 15 of each year, with the exception of the initial offering period, which commenced on March 26, 2014 and ended on November 14, 2014. Employees may contribute a minimum of 1% and a maximum of 15% of their earnings. During the nine months ended September 30, 2015, employees purchased 107,858 shares under the ESPP at a price of $25.25 per share for cash proceeds of $2.7 million.
Stock Repurchases
During the nine months ended September 30, 2015, the Company repurchased 1,895,625 shares of outstanding common stock for $48.4 million. On June 29, 2015, the Board approved the repurchase of an additional $50.0 million of its outstanding common stock in the aggregate under the existing stock repurchase program. As of September 30, 2015, a total of approximately $31.6 million remained available for further repurchases of the Company’s common stock under the Company’s stock repurchase program.

15


Stock-Based Compensation
Stock-based compensation expense of $13.0 million and $8.3 million was recognized for the nine months ended September 30, 2015 and 2014, respectively. Income tax benefit of $4.2 million and $2.0 million was recognized relating to stock-based compensation expense for the nine months ended September 30, 2015 and 2014, respectively. The tax benefit realized from stock options exercised was $16.4 million and $6.4 million for the nine months ended September 30, 2015 and 2014, respectively.
The fair value of stock-based awards is estimated on the date of grant using the Black-Scholes option-pricing model with the following weighted-average assumptions:
Stock Option Assumptions
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Expected term (in years)
6.11

 
6.08

 
6.08-6.11

 
6.04-6.08

Expected volatility
46
%
 
41
%
 
39-46%

 
41-58%

Risk-free interest rate
1.62
%
 
1.85
%
 
1.62-1.96%

 
1.74-1.96%

Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
 
 
ESPP Assumptions
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Expected term (in years)
0.50

 
0.64

 
0.50

 
0.64

Expected volatility
43
%
 
58
%
 
34-43%

 
58
%
Risk-free interest rate
0.08
%
 
0.06
%
 
0.07-0.08%

 
0.06
%
Expected dividend yield
0
%
 
0
%
 
0
%
 
0
%
 
The volatility for the offering periods beginning on May 18, 2015, November 16, 2014 and March 26, 2014 were 43%, 33% and 58%, respectively.
 
Stock-based compensation expense for stock-based awards made to the Company’s employees pursuant to the equity plans was as follows (in thousands): 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Cost of providing services
$
1,079

 
$
843

 
$
3,051

 
$
2,098

Sales and marketing
1,029

 
771

 
3,255

 
2,062

General and administrative
1,633

 
1,280

 
5,497

 
3,333

Systems development and programming costs
447

 
287

 
1,188

 
758

 
$
4,188

 
$
3,181

 
$
12,991

 
$
8,251


NOTE 9: EARNINGS PER SHARE
Prior to its IPO, the Company’s basic and diluted earnings per share (EPS) were computed using the two-class method, an earnings allocation method that determines earnings per share for common stock and participating securities. Shares of convertible preferred stock are considered participating securities and are entitled to dividend, on a pro rata basis, upon redemption, as if these had been converted to common stock. The undistributed earnings are allocated between common stock and participating securities as if all earnings had been distributed during the period.
Basic EPS is calculated by taking net income, less earnings available to participating securities, divided by the basic weighted average common stock outstanding.
Diluted EPS is calculated using the more dilutive of the if-converted method and the two-class method. Because the preferred stock participates in dividends on a pro rata basis as if the shares had been converted, the diluted earnings per share are the same under both methods. The two-class method has been presented below.

16


The following table sets forth the computation of the Company’s basic and diluted net income per share attributable to common stock (in thousands, except per share data):
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Numerator (basic)
 
 
 
 
 
 
 
Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Less net income allocated to participating securities
—

 
—

 
—

 
(1,658
)
Net income attributable to common stock
$
3,097

 
$
725

 
$
17,600

 
$
6,828

Denominator (basic)
 
 
 
 
 
 
 
Weighted average shares of common stock outstanding
70,238

 
69,135

 
70,247

 
51,655

Basic EPS
$
0.04

 
$
0.01

 
$
0.25

 
$
0.13

Numerator (diluted)
 
 
 
 
 
 
 
Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Less net income allocated to participating securities
—

 
—

 
—

 
(1,576
)
Net income attributable to common stock
$
3,097

 
$
725

 
$
17,600

 
$
6,910

Denominator (diluted)
 
 
 
 
 
 
 
Weighted average shares of common stock
70,238

 
69,135

 
70,247

 
51,655

Dilutive effect of stock options and restricted stock units
1,850

 
3,819

 
2,510

 
3,349

Weighted average shares of common stock outstanding
72,088

 
72,954

 
72,757

 
55,004

Diluted EPS
$
0.04

 
$
0.01

 
$
0.24

 
$
0.13

 
 
 
 
 
 
 
 
Common stock equivalents excluded from diluted weighted average shares of common stock outstanding because of their anti-dilutive effect
1,321

 
129

 
957

 
595


NOTE 10. INCOME TAXES
The Company is subject to income taxation in the United States and Canada. However, business is conducted primarily in the United States. The effective income tax rate differs from the statutory rate primarily due to state taxes, non-deductible stock-based compensation, and tax credits. The Company makes estimates and judgments about its future taxable income that are based on assumptions that are consistent with the Company’s plans and estimates. Should the actual amounts differ from these estimates, the amount of the valuation allowance could be materially affected.
Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Changes in valuation allowances are reflected as a component of provision for income taxes.
The Company’s effective income tax rate was 57.9% and 75.5% for the three months ended September 30, 2015 and 2014, respectively, and 49.6% and 51.9% for the nine months ended September 30, 2015 and 2014, respectively. The decrease is primarily due to a 2014 discrete charge for the revaluation of deferred taxes based on an income tax accounting method change approved by the Internal Revenue Service (IRS) in the third quarter of 2014. The remainder of the decrease is primarily due to disqualifying dispositions on previously non-deductible stock-based compensation.
The Company is subject to taxation under the laws of the U.S. and various state and local jurisdictions, as well as Canada. The Company is not subject to any material income tax examinations by U.S. federal or state tax authorities for tax years beginning prior to January 1, 2010.  The Company paid Notices of Proposed Assessments outstanding as of December 31, 2014 related to the disallowance of employment tax credits totaling $10.5 million in connection with the IRS examination of Gevity HR, Inc. and its subsidiaries, which was acquired by TriNet in June 2009.  The Company plans to exhaust all administrative efforts to resolve this matter, however, it is likely that the matter will ultimately be resolved through litigation.  With regard to these employment tax credits, the Company believes it is more likely than not that the Company will prevail.  Therefore, no reserve has been recognized related to this matter.

17


NOTE 11. COMMITMENTS AND CONTINGENCIES
Lease Commitments
The Company leases office facilities, including its headquarters and other facilities, and equipment under non-cancelable operating leases. The Company also leases certain software and furniture, fixtures, and equipment under capital leases. The lease agreements generally provide for rental payments on a graduated basis and for options to renew, which could increase future minimum lease payments if exercised. The Company recognizes rent expense on a straight-line basis over the lease period and accrues for rent expense incurred but not paid. Rent expense for the three months ended September 30, 2015 and 2014 was $3.2 and $3.1 million, respectively. Rent expense for the nine months ended September 30, 2015 and 2014 was $9.5 million and $8.7 million, respectively.   
Operating Covenants
To meet various states’ licensing requirements and maintain accreditation by the Employer Services Assurance Corporation, the Company is subject to various minimum working capital and net worth requirements. As of September 30, 2015, the Company believes it has fully complied in all material respects with all applicable state regulations regarding minimum net worth, working capital and all other financial and legal requirements. Further, the Company has maintained positive working capital throughout the period covered by the financial statements.
Contingencies    
On or about August 7, 2015, Howard Welgus, a purported stockholder of the Company, filed a putative securities class action arising under the Securities and Exchange Act of 1934 in the United States District Court for the Northern District of California. The name of the case is Welgus v. TriNet Group, Inc. et al., Case No. 3:15-cv-03625. The defendants named in the case are the Company and certain of its officers. The complaint generally alleges that the Company caused damage to stockholders of the Company by misrepresenting and/or failing to disclose facts generally pertaining to alleged trends impacting health insurance and worker compensations claims. The case has not been certified as a class action, although it purports to be filed on behalf of purchasers of the Company's common stock between May 5, 2014 and August 3, 2015, inclusive. No stockholder other than Mr. Welgus submitted a motion for appointment as lead plaintiff to represent the putative class in the case prior to the October 6, 2015 deadline for such motions. A Court hearing has been set for December 10, 2015 on Mr. Welgus's motion for appointment as lead plaintiff. The Company believes that it has meritorious defenses against this action and intends to continue to defend itself vigorously against the allegations of Mr. Welgus.
The Company is and, from time to time, has been and may in the future become involved in various litigation matters, legal proceedings and claims arising in the ordinary course of its business, including disputes with its clients or various class action, collective action, representative action and other proceedings arising from the nature of its co-employment relationship with its customers and WSEs in which the Company is named as a defendant. In addition, due to the nature of the Company’s co-employment relationship with its customers and WSEs, the Company could be subject to liability for federal and state law violations, even if the Company does not participate in such violations. While the Company’s agreements with its customers contain indemnification provisions related to the conduct of its customers, the Company may not be able to avail itself of such provisions in every instance.
While the outcome of the matters described above cannot be predicted with certainty, management currently does not believe that any such claims or proceedings or the above mentioned securities class action will have a materially adverse effect on the Company’s consolidated financial position, results of operations or cash flows. However, the unfavorable resolution of any particular matter or the Company’s reassessment of its exposure for any of the above matters based on additional information obtained in the future could have a material impact on the Company’s consolidated financial position, results of operations or cash flows. In addition, regardless of the outcome, the above matters, individually and in the aggregate, could have an adverse impact on the Company because of diversion of management resources and other factors.




18


Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
You should read the following discussion of our financial condition and results of operations in conjunction with our consolidated financial statements and the related notes included elsewhere in this Quarterly Report on Form 10-Q and our Annual Report on Form10-K filed with the Securities and Exchange Commission on March 30, 2015. We also encourage you to review the risks and uncertainties described in the section titled “Risk Factors” included in this Quarterly Report under Part II, Item 1A below. Unless the context suggests otherwise, references to “TriNet,” the “Company,” “we,” “us” and “our” refer to TriNet Group, Inc. and, where appropriate, its subsidiaries.
Special Note Regarding Forward-Looking Statements
This report contains forward-looking statements within the meaning of Section 27A of the Securities Act and Section 21E of the Securities Exchange Act of 1934, as amended, or the Exchange Act. Forward-looking statements are often identified by the use of words such as, but not limited to, “anticipate,” “believe,” “can,” “continue,” “could,” “estimate,” “expect,” “intend,” “may,” “plan,” “project,” “seek,” “should,” “strategy,” “target,” “will,” “would” and similar expressions or variations intended to identify forward-looking statements. These statements are not guarantees of future performance, but are based on management’s expectations as of the date of this report and assumptions that are inherently subject to uncertainties, risks and changes in circumstances that are difficult to predict. Forward-looking statements involve known and unknown risks, uncertainties and other factors that may cause actual results, performance or achievements to be materially different from any future results, performance or achievements. Important factors that could cause actual results to differ materially from those expressed or implied by these forward-looking statements include, but are not limited to, those identified below and those discussed in the section titled “Risk Factors” included under Part II, Item 1A below. All information provided in this report is as of the date of this report and the company undertakes no duty to update this information except as required by law.
Overview
TriNet is a leading provider of a comprehensive human resources solution for small to medium-sized businesses, or SMBs. We enhance business productivity by enabling our clients to outsource their human resources, or HR, function to one strategic partner and allowing them to focus on operating and growing their core businesses. Our HR solution includes services such as payroll processing, human capital consulting, employment law compliance and employee benefits, including health insurance, retirement plans and workers compensation insurance. Our services are delivered by our expert team of HR professionals and enabled by our proprietary, cloud-based technology platform, which allows our clients and their employees to efficiently conduct their HR transactions anytime and anywhere. We believe we are a leader in the industry due to our size, our presence in the United States and Canada and the number of clients and employees that we serve.
We utilize a co-employment model pursuant to which both we and our clients become employers of our clients’ employees, which we refer to as worksite employees, or WSEs. This model affords us a close and embedded relationship with our clients and their employees. Under the co-employment model, employment-related liabilities are contractually allocated between us and our clients. We assume responsibility for, and manage the risks associated with, each client’s employee payroll obligations, including the liability for payment of salaries and wages to each client employee, the payment of payroll taxes and, at the client’s option, responsibility for providing group health, welfare, workers compensation and retirement benefits to such individuals. Unlike a payroll service provider, we issue each WSE a payroll check drawn on our bank accounts and contract with insurance carriers to provide health and workers compensation insurance to WSEs under TriNet’s name.
We serve thousands of clients in specific industry vertical markets, including technology, life sciences, property management, professional services, banking and financial services, retail, manufacturing and hospitality services, as well as non-profit entities. As of September 30, 2015, we served over 12,000 clients in all 50 states, the District of Columbia and Canada and co-employed approximately 315,000 WSEs.
Our total revenues consist of professional service revenues and insurance service revenues. For each of the three and nine months ended September 30, 2015, 15% of our total revenues consisted of professional service revenues, and 85% of our total revenues consisted of insurance service revenues. For each of the three and nine months ended September 30, 2014, 16% of our total revenues consisted of professional service revenues, and 84% of our total revenues consisted of insurance service revenues. We earn professional service revenues by processing HR transactions, such as payroll and employment tax withholding, and providing labor and benefit law compliance services, on behalf of our clients. We earn insurance service revenues by providing risk-based, third-party plans to our clients, primarily employee health benefit plans and workers compensation insurance.

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For professional service revenues, we recognize as revenues the fees we earn for processing HR transactions, which fees do not include the payroll that is paid to us by the client and paid out to WSEs or remitted as taxes. We recognize as insurance service revenues all insurance-related billings and administrative fees collected from clients and withheld from WSEs for risk-based insurance plans provided through third-party insurance carriers, primarily employee health insurance and workers compensation insurance. We in turn pay premiums to third-party insurance carriers for these insurance benefits, as well as reimburse them for claim payments within our insurance deductible layer. These premiums and reimbursements are classified as insurance costs on our statements of operations. To augment our financial information prepared in accordance with U.S. generally accepted accounting principles, or GAAP, we use internally non-GAAP financial measures of revenues, including Net Insurance Service Revenues, which consists of insurance service revenues less insurance costs, and Net Service Revenues, which is the sum of professional service revenues and Net Insurance Service Revenues. For the three months ended September 30, 2015 and 2014, 74% and 68% of our Net Service Revenues, respectively, consisted of professional service revenues and 26% and 32% of our Net Service Revenues, respectively, consisted of Net Insurance Service Revenues. For the nine months ended September 30, 2015 and 2014, 74% and 66% of our Net Service Revenues, respectively, consisted of professional service revenues and 26% and 34% of our Net Service Revenues, respectively, consisted of Net Insurance Service Revenues.
We sell our services primarily through our direct sales force, which consists of sales representatives who focus on serving clients in specific industry vertical markets. For the three months ended September 30, 2015 and 2014, our sales and marketing expenses were $45.0 million and $37.4 million, respectively, or 7% and 7% of our total revenues and 34% and 29% of our Net Service Revenues, respectively. For the nine months ended September 30, 2015 and 2014, our sales and marketing expenses were $123.7 million and $104.2 million, respectively, or 6% and 7% of our total revenues and 31% and 27% of our Net Service Revenues, respectively.
We have made significant investments in our proprietary, cloud-based technology platform, including implementing client information and management software to provide our clients with enhanced features and functionality with which to conduct their HR transactions, manage their employees and analyze employee benefits data. For the three months ended September 30, 2015 and 2014, our systems development and programming costs were $7.0 million and $6.8 million, respectively, representing 1% of our total revenues and 5% of our Net Service Revenues in each period. For the nine months ended September 30, 2015 and 2014, our systems development and programming costs were $21.8 million and $19.2 million, respectively, representing 1% of our total revenues and 5% of our Net Service Revenues in each period.
Strategic Acquisitions
We operate in a highly fragmented industry and have completed numerous strategic acquisitions over the course of the past decade. We intend to continue to pursue strategic acquisitions that will enable us to add new clients and employees to our existing business and offer our clients and their employees more comprehensive and attractive services. Because many of the companies we have acquired to date were focused on specific industries, our acquisitions have allowed us to expand our vertical service offerings into areas such as financial services, property management and food services, hospitality and manufacturing in which we did not previously have a significant presence. In addition, through acquisition activities we have added sales representatives with experience in these vertical markets. Our acquisitions have provided us with additional clients and WSEs to allow us to continue to leverage our operations over a larger client base. Our operations could be adversely impacted if our strategic acquisitions are not integrated effectively, but we expect to continue to pursue strategic acquisitions as part of our overall business strategy.
Key Operating Metrics
We regularly review certain key operating metrics to evaluate growth trends, measure our performance and make strategic decisions. Our key operating metrics as of and for the three and nine months ended September 30, 2015 and 2014 were as follows:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
Net Insurance Service Revenues (in thousands)
$
34,054

 
$
40,903

 
$
103,627

 
$
128,334

Net Service Revenues (in thousands)
$
133,527

 
$
127,767

 
$
397,915

 
$
380,333

Total WSEs
314,930

 
272,846

 
 
 
 
Total Sales Representatives
479

 
391

 
 
 
 
 

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Total WSEs
We define Total WSEs at the end of a given fiscal period as the total number of WSEs paid in the last calendar month of the fiscal period. We believe that comparing our Total WSEs at the end of a fiscal period to that of prior periods is an indicator of our success in growing our business, both organically and through the integration of acquired businesses, and retaining clients, and that our Total WSEs paid in the last calendar month of the fiscal period is a leading indicator of our anticipated revenues for future fiscal periods.
Total Sales Representatives
Our direct sales force consists of sales representatives who focus on serving clients in specific industry vertical markets. We define Total Sales Representatives at the end of a given fiscal period as the total number of our direct sales force employees at that date. We believe that comparing our Total Sales Representatives at the end of a fiscal period to our Total Sales Representatives at the end of a prior fiscal period is an indicator of our success in growing our business, and that our Total Sales Representatives at the end of recent fiscal periods is a key indicator of our ability to increase our revenues in the following fiscal periods.
Net Insurance Service Revenues and Net Service Revenues
We define Net Insurance Service Revenues as insurance service revenues less insurance costs. We define Net Service Revenues as the sum of professional service revenues and Net Insurance Service Revenues. Our total revenues on a GAAP basis represent the total amount invoiced by us to our clients, net of direct pass-through costs such as payroll and payroll tax payments, for the services we provide to our clients. Our insurance costs include the premiums we pay to insurance carriers for the health and workers compensation insurance coverage provided to our clients and WSEs and the reimbursements we pay to the insurance carriers for claim payments within our insurance deductible layer. We act principally as the service provider to add value in the execution and procurement of these services to our clients. Net Insurance Service Revenues is the primary indicator of our ability to source, add value and offer benefit services to WSEs through third-party insurance carriers, and is considered by management to be a key performance measure. We believe that Net Service Revenues is also a key performance measure as it provides a useful measure of total revenues for the two main components of our revenues calculated on a consistent basis. In addition, management believes measuring operating costs as a function of Net Service Revenues provides a useful metric, as we believe it enables better evaluation of the performance of our business.
Impact of Health Care Reform
The Patient Protection and Affordable Care Act and the Heath Care and Education Reconciliation Act of 2010, which we refer to collectively as the Act, entail sweeping health care reforms with staggered effective dates from 2010 through 2018, and many provisions of the Act require the issuance of additional guidance from the U.S. Departments of Labor and Health and Human Services, the Internal Revenue Service, or IRS, and U.S. states. A number of key provisions of the Act began to take effect in 2014, including the establishment of state and federal insurance exchanges, insurance market reforms, “pay or play” penalties on applicable large employers and the imposition and assessment of excise taxes on the health insurance industry and reinsurance taxes on insurers and third-party administrators. Collectively, these items have the potential to significantly change the insurance marketplace for employers and how employers offer or provide insurance to employees.
We are not yet able to determine the impacts to our business, and to our clients, resulting from the Act. In future periods, the Act may result in increased costs to us and our clients and could affect our ability to attract and retain clients. Additionally, we may be limited or delayed in our ability to increase service fees to offset any associated potential increased costs resulting from compliance with the Act. Furthermore, the uncertainty surrounding the terms and application of the Act may delay or inhibit the decisions of potential clients to outsource their HR needs. As a result, these changes could have a negative impact on our operating results.
Seasonality and Insurance Variability
Historically, we have experienced our highest monthly addition of WSEs, as well as our highest monthly levels of client attrition, in the month of January, primarily because clients that change their payroll service providers tend to do so at the beginning of a calendar year. In addition, we experience higher levels of client attrition during the fourth quarter and, to a lesser extent, during the first quarter of the calendar year, in connection with renewals of the health insurance we provide for our WSEs, in the event that such renewals result in increased premiums that we pass on to our clients. We have also historically experienced higher insurance claim volumes in the second and third quarters of a fiscal year than in the first and fourth quarters of a fiscal year, as WSEs typically access their health care providers more often in the second and third quarters of a fiscal year,

21


which has negatively impacted our insurance costs in these quarters. We have also experienced variability on a quarterly basis in the amount of insurance costs due to the number and severity of insurance claims being unpredictable. These historical trends may change, and other seasonal trends and variability may develop that make it more difficult for us to manage our business.
Non-GAAP Financial Results
We use Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income to provide an additional view of our operational performance. Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income are financial measures that are not prepared in accordance with GAAP. We define Net Insurance Service Revenues as insurance service revenues less insurance costs, which include the premiums we pay to insurance carriers for the health and workers compensation insurance coverage provided to our clients and WSEs and the reimbursements we pay to the insurance carriers for claim payments within our insurance deductible layer. We define Net Service Revenues as the sum of professional service revenues and Net Insurance Service Revenues. We define Adjusted EBITDA as net income, excluding the effects of our income tax provision, interest expense, depreciation, amortization of intangible assets, stock-based compensation expense and, in 2014, certain costs related to a public offering of our shares of common stock. We define Adjusted Net Income as net income, excluding the effects of our effective income tax rate, stock-based compensation, amortization of intangible assets, non-cash interest expense, debt prepayment premium, the income tax effect of these pre-tax adjustments at our effective tax rate and, in 2014, certain costs related to a public offering of our shares of common stock. For purposes of our non-GAAP financial presentation, as a result of a 2015 increase in New York City tax rates and, in the third quarter of 2015, an increase in blended state rates, we have adjusted the effective tax rate to 41.5% for the three and nine month periods ended September 30, 2015, from 39.5% for three and nine month periods ended September 30, 2014. Each of these effective tax rates exclude income tax on non-deductible stock-based compensation and discrete items including the cumulative effect of state law changes. Non-cash interest expense represents amortization and write-off of our debt issuance costs.
We believe that the use of Net Insurance Service Revenues provides useful information as it presents a measure of revenues from our provision of insurance services to our clients that eliminates the cost of insurance. We believe that Net Service Revenues provides a useful measure of total revenues for the two main components of our revenues calculated on a consistent basis. We believe that the use of Adjusted EBITDA and Adjusted Net Income provides additional period-to-period comparisons and analysis of trends in our business, as they exclude certain one-time and non-cash expenses. We believe that Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income are useful for our stockholders and board of directors by helping them to identify trends in our business and understand how our management evaluates our business. We use Net Insurance Service Revenues, Net Service Revenues and Adjusted EBITDA to monitor and evaluate our operating results and trends on an ongoing basis and internally for operating, budgeting and financial planning purposes, in addition to allocating our resources to enhance the financial performance of our business and evaluating the effectiveness of our business strategies. We also use Net Service Revenues and Adjusted EBITDA in determining the incentive compensation for management.
Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income are not prepared in accordance with, and should not be considered in isolation of, or as an alternative to, measurements required by GAAP. In addition, these non-GAAP measures are not based on any comprehensive set of accounting rules or principles. As non-GAAP measures, Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income have limitations in that they do not reflect all of the amounts associated with our results of operations as determined in accordance with GAAP. In particular:
•
Net Insurance Service Revenues and Net Service Revenues are reduced by the insurance costs that we pay to the insurance carriers;
•
Adjusted EBITDA does not reflect interest expense, or the cash requirements necessary to service interest or principal payments on our debt;
•
Adjusted EBITDA does not reflect the amounts we paid in taxes or other components of our tax provision;
•
Adjusted EBITDA does not reflect our cash expenditures or future requirements for capital expenditures or contractual commitments;
•
Adjusted EBITDA and Adjusted Net Income do not reflect changes in, or cash requirements for, our working capital needs;
•
Adjusted EBITDA and Adjusted Net Income do not reflect the non-cash component of employee compensation;

22


•
Although depreciation and amortization of intangible assets are non-cash charges, the assets being depreciated and amortized often will have to be replaced in the future, and Adjusted EBITDA does not reflect any cash requirements for such replacements; and
•
Other companies in our industry may calculate these measures or similar measures differently than we do, limiting their usefulness as a comparative measure.
Because of these limitations, you should consider Net Insurance Service Revenues, Net Service Revenues, Adjusted EBITDA and Adjusted Net Income alongside other financial performance measures, including total revenues, net income and our financial results presented in accordance with GAAP.
The table below sets forth a reconciliation of GAAP insurance service revenues to Net Insurance Service Revenues:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Insurance service revenues
$
568,535

 
$
469,087

 
$
1,639,305

 
$
1,337,870

Less:  Insurance costs
534,481

 
428,184

 
1,535,678

 
1,209,536

Net Insurance Service Revenues
$
34,054

 
$
40,903

 
$
103,627

 
$
128,334


The table below sets forth a reconciliation of GAAP total revenues to Net Service Revenues:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Total revenues
$
668,008

 
$
555,951

 
$
1,933,593

 
$
1,589,869

Less:  Insurance costs
534,481

 
428,184

 
1,535,678

 
1,209,536

Net Service Revenues
$
133,527

 
$
127,767

 
$
397,915

 
$
380,333

 
The table below sets forth a reconciliation of GAAP net income to Adjusted EBITDA:
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Provision for income taxes
4,255

 
2,238

 
17,328

 
9,149

Stock-based compensation
4,188

 
3,181

 
12,991

 
8,251

Interest expense and bank fees
4,685

 
18,462

 
14,653

 
49,174

Depreciation
4,132

 
3,265

 
10,761

 
9,725

Amortization of intangible assets
10,459

 
12,743

 
32,284

 
39,559

Secondary offering costs
—

 
858

 
—

 
858

Adjusted EBITDA
$
30,816

 
$
41,472

 
$
105,617

 
$
125,202

 

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The table below sets forth a reconciliation of GAAP net income to Adjusted Net Income: 
 
Three Months Ended
September 30,
 
Nine Months Ended
September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

Effective income tax rate adjustment
1,204

 
1,068

 
2,833

 
2,183

Stock-based compensation
4,188

 
3,181

 
12,991

 
8,251

Amortization of intangible assets
10,459

 
12,743

 
32,284

 
39,559

Non-cash interest expense
799

 
13,602

 
2,820

 
21,088

Debt prepayment premium
—

 
—

 
—

 
3,800

Secondary Offering Costs
—

 
858

 
—

 
858

Income tax impact of pre-tax adjustments
(6,410
)
 
(12,002
)
 
(19,959
)
 
(29,055
)
Adjusted Net Income
$
13,337

 
$
20,175

 
$
48,569

 
$
55,170


Basis of Presentation and Key Components of Our Results of Operations
Total Revenues
Our total revenues consist of professional service revenues and insurance service revenues.
We earn professional service revenues by processing HR transactions, such as payroll and employment tax withholding, payment to WSEs, and labor and benefit law compliance, on behalf of our clients. Our clients pay us these fees based on either a fixed fee per WSE per month or per transaction, or a percentage of the WSE’s payroll cost, pursuant to written professional services agreements that are generally cancelable by us or our clients upon 30 days’ prior written notice. We also earn professional service revenues by providing strategic HR services to our clients, such as talent acquisition, performance management and time and expense reporting services. Our clients pay us professional service fees for these services based on separate written agreements.
We earn insurance service revenues by providing risk-based, third-party plans to our clients, primarily employee health benefit plans and workers compensation insurance. Insurance service revenues consist of insurance-related billings and administrative fees. We recognize as insurance service revenues insurance-related billings and administrative fees collected from clients and withheld from WSEs for risk-based insurance plans provided through third-party insurance carriers, primarily employee health insurance and workers compensation insurance. We in turn pay premiums to third-party insurance carriers for these insurance benefits, as well as reimburse them for claim payments within our insurance deductible layer. These premiums and reimbursements are classified as insurance costs on our statements of operations.
Our clients pay us administrative fees, typically based on a percentage of insurance-related amounts, collected from clients and withheld from WSEs, primarily in exchange for our administration of employee health benefit plans.
Insurance Costs
Insurance costs include the premiums we pay to the insurance carriers for the health and workers compensation insurance coverage provided to the clients and WSEs and the reimbursements we pay to the insurance carriers for claim payments made to the WSEs within the insurance deductible layer.
Our insurance costs are, in part, a function of the type and terms of agreements that we enter into with the insurance carriers that provide fully-insured coverage for our WSEs. Our future premiums under these, or ensuing, policies will be influenced by the WSE claims activity in prior periods. The remainder of the health insurance policies and all of the workers compensation insurance policies that we provide to our clients are policies with respect to which we agree to reimburse our carriers for any claims that they pay within our deductible layer. Under these policies, WSEs file claims with the carriers, which are responsible for paying the claims up to the maximum coverage under the policies. The carriers then seek reimbursement from us up to our deductible per incident for workers compensation claims, or up to a cap for health insurance claims in accordance with the terms of the underlying health insurance policies. In no event are we liable to pay the claims directly to WSEs. As we evaluate the claims experience for each fiscal period, we adjust, as we deem necessary, our workers compensation and health benefits reserves, and this in turn has a corresponding impact on our insurance costs. As a result, our

24


insurance costs fluctuate from period to period depending on the number and severity of the claims incurred by our WSEs. We expect our insurance costs to continue to increase in absolute dollars on an annual basis for the foreseeable future due to expected growth in WSEs. We also expect our insurance costs to continue to fluctuate on a quarterly basis due to variability in the number and severity of claims.
Cost of Providing Services
Cost of providing services consists primarily of costs incurred by us associated with direct customer support, such as payroll and benefits processing, professional HR consultants, employee liability insurance and costs associated with defending clients in employment-related legal claims, benefits and risk management, postage and shipping expenses and consulting expenses. We expect our cost of providing services to continue to increase in absolute dollars on an annual basis for the foreseeable future due to expected growth in WSEs, partially offset by improved efficiencies, although these expenses may fluctuate as a percentage of our total revenues from period to period depending on the timing of those expenses.
Sales and Marketing Expenses
Sales and marketing expenses consist primarily of salaries, commissions and related variable compensation expenses, commission payments to partners and the cost of marketing programs. Marketing programs consist of advertising, lead generation, marketing events, corporate communications, brand building and product marketing activities, as well as various incentivized partnership and referral programs. We expect our sales and marketing expenses to continue to increase, both in absolute dollars and as a percentage of our total revenues on an annual basis, for the foreseeable future as we expand our sales force and our other sales and marketing efforts to build our brand, although these expenses may fluctuate as a percentage of our total revenues from period to period depending on the timing of those expenses.
General and Administrative Expenses
General and administrative expenses consist primarily of compensation-related expenses, legal and other professional services fees and other general corporate expenses. We expect our general and administrative expenses to continue to increase in absolute dollars for the foreseeable future due to increases in our legal and financial compliance costs in connection with being a newly public company, although these expenses may fluctuate as a percentage of our total revenues from period to period depending on the timing of those expenses.
Systems Development and Programming Costs
Systems development and programming costs consist primarily of compensation-related expenses for our employees and contractors dedicated to systems development and programming, as well as fees that we pay to third-party consulting firms. We expect our systems development and programming costs to continue to increase modestly in absolute dollars for the foreseeable future as we continue to invest in and improve our technology platform. However, over time, we expect our systems development and programming costs to remain relatively consistent as a percentage of our total revenues on an annual basis, although these costs may fluctuate as a percentage of our total revenues from period to period depending on when we incur those costs.
Amortization of Intangible Assets
Amortization of intangible assets represents costs associated with an acquired company’s developed technologies, client lists, trade names and contractual agreements. We amortize these intangibles over their respective estimated useful lives using either the straight-line method or the accelerated method.
Depreciation
Depreciation consists primarily of amortization of the cost of software and furniture, fixtures and equipment.
Other Income (Expense)
Other income (expense) consists primarily of interest expense under our credit facility and capital leases, debt issuance cost amortization, and, in 2014, a prepayment premium.

25


Provision for Income Taxes
We are subject to taxation in the United States and Canada. We conduct our business primarily in the United States, and all of our clients are U.S. employers. However, we provide services to certain clients with employees in Canada. The percentage of our total revenues attributable to WSEs in Canada was less than 1% for each of the three and nine months ended September 30, 2015 and 2014. Our effective tax rate differs from the statutory rate primarily due to state taxes, tax credits, non-deductible charges, changes in uncertain tax positions, and other discrete items. We make estimates and judgments about our future taxable income based on assumptions that are consistent with our plans and estimates. Should the actual amounts differ from our estimates, the amount of our valuation allowance could be materially affected.
Income taxes are computed using the asset and liability method, under which deferred tax assets and liabilities are determined based on the difference between the financial statement and tax bases of assets and liabilities using enacted tax rates in effect for the year in which the differences are expected to affect taxable income. Valuation allowances are established when necessary to reduce deferred tax assets to the amount expected to be realized. Changes in valuation allowances are reflected as a component of provision for income taxes.
Critical Accounting Policies, Estimates and Judgments
Our consolidated financial statements are prepared in accordance with U.S. generally accepted accounting principles, or GAAP. The preparation of financial statements in conformity with GAAP requires management to make estimates and assumptions that affect certain reported amounts and disclosures. These estimates include, but are not limited to, allowances for accounts receivable, workers compensation related assets and liabilities, health plan assets and liabilities, recoverability of goodwill and other intangible assets, income taxes, stock-based compensation and other contingent liabilities. Such estimates are based on historical experience and on various other assumptions that Company management believes to be reasonable under the circumstances. Actual results could differ significantly from our estimates. To the extent that there are material differences between these estimates and actual results, our future financial statement presentation, financial condition, results of operations and cash flows will be affected.
This Quarterly Report on Form 10-Q should be read in conjunction with the consolidated financial statements and accompanying notes included in our Annual Report on Form 10-K for the year ended December 31, 2014, filed with the SEC on March 30, 2015.  
Recent Accounting Pronouncements
In September 2015, the Financial Accounting Standards Board, or FASB issued Accounting Standards Update (ASU) 2015-16—Business Combinations, as part of its initiative to reduce complexity in accounting standards (the Simplification Initiative). The amendment eliminates the requirement to retrospectively apply adjustments made to provisional amounts recognized in a business combination. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2016. Early adoption is permitted. We expect to adopt this guidance in the current fiscal year. We do not expect this guidance to have a material effect on our consolidated financial statements.
In April 2015, the FASB issued ASU 2015-05—Intangibles—Goodwill and Other—Internal-Use Software, as part of the Simplification Initiative. The amendment provides guidance to clarify the customer’s accounting for fees paid in a cloud computing arrangement. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted. We expect to adopt this guidance in 2016. We do not expect this guidance to have a material effect on our consolidated financial statements.
In April 2015, the FASB issued ASU 2015-03— Interest—Imputation of Interest, as part of its Simplification Initiative. The amendment requires that debt issuance costs related to a recognized debt liability be presented in the balance sheet as a direct deduction from the carrying amount of that debt liability, consistent with debt discounts. The amendment is effective for fiscal years, and interim periods within those fiscal years, beginning after December 15, 2015. Early adoption is permitted for financial statements that have not been previously issued. We are currently evaluating the impact that the adoption of this guidance will have on our consolidated financial statements.
In August 2014, the FASB issued ASU 2014-15—Presentation of Financial Statements — Going Concern (Subtopic 205-40), which addresses management’s responsibility to evaluate whether there is substantial doubt about an entity’s ability to continue as a going concern and to provide related footnote disclosures. Management’s evaluation should be based on relevant conditions and events that are known and reasonably knowable at the date that the financial statements are issued. The standard will be effective for the first interim period within annual reporting periods beginning after December 15, 2016. Early adoption is permitted. We do not expect to adopt this guidance early and do not believe that the adoption of this guidance will have a material effect on our consolidated financial statements.

26


In June 2014, the FASB issued ASU 2014-12—Compensation - Stock Compensation, which requires that a performance target that affects vesting and that could be achieved after the requisite service period be treated as a performance condition. ASU 2014-12 is effective for annual reporting periods, and interim periods within those years, beginning after December 15, 2015. Early adoption is permitted. The amendments may be applied prospectively to all awards granted or modified after the effective date or retrospectively to all awards with performance targets that are outstanding as of the beginning of the earliest annual period presented. We do not expect this guidance to have a material effect on our consolidated financial statements. We expect to adopt this guidance in 2016.
In May 2014, the FASB issued ASU 2014-09—Revenue from Contracts with Customers, which will replace most existing revenue recognition guidance under GAAP. The core principle of the guidance is that an entity should recognize revenue to depict the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in exchange for those goods or services. The standard provides a five-step analysis of transactions to determine when and how revenue is recognized. In July 2015, the FASB deferred the effective date to annual reporting periods, and interim periods within those years, beginning after December 15, 2017. Early adoption at the original effective date of December 15, 2016 is permitted. The amendments may be applied retrospectively or as a cumulative-effect adjustment as of the date of adoption. We have not yet selected a method of adoption and are currently evaluating the effect that the amendments will have on our consolidated financial statements.


27


Results of Operations
The following tables set forth our results of operations for the periods presented and as a percentage of our total revenues and Net Service Revenues for those periods. Period-to-period comparisons of our financial results are not necessarily indicative of financial results to be achieved in future periods. 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Consolidated Statement of Operations:
(in thousands)
Professional service revenues
$
99,473

 
$
86,864

 
$
294,288

 
$
251,999

Insurance service revenues
568,535

 
469,087

 
1,639,305

 
1,337,870

Total revenues
668,008

 
555,951

 
1,933,593

 
1,589,869

Costs and operating expenses:
 
 
 
 
 
 
 
Insurance costs
534,481

 
428,184

 
1,535,678

 
1,209,536

Cost of providing services (exclusive of depreciation and
   amortization of intangible assets) (1)
37,540

 
32,575

 
111,582

 
100,252

Sales and marketing (1)
44,997

 
37,396

 
123,740

 
104,225

General and administrative (1)
17,726

 
13,766

 
48,991

 
40,785

Systems development and programming costs (1)
6,991

 
6,776

 
21,849

 
19,235

Amortization of intangible assets
10,459

 
12,743

 
32,284

 
39,559

Depreciation
4,132

 
3,265

 
10,761

 
9,725

Total costs and operating expenses
656,326

 
534,705

 
1,884,885

 
1,523,317

Operating income
11,682

 
21,246

 
48,708

 
66,552

Other income (expense):
 
 
 
 
 
 
 
Interest expense and bank fees
(4,685
)
 
(18,462
)
 
(14,653
)
 
(49,174
)
Other, net
355

 
179

 
873

 
257

Income before provision for income taxes
7,352

 
2,963

 
34,928

 
17,635

Provision for income taxes
4,255

 
2,238

 
17,328

 
9,149

Net income
$
3,097

 
$
725

 
$
17,600

 
$
8,486

 
(1)
Includes stock-based compensation expense as follows:
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
 
(in thousands)
Cost of providing services
$
1,079

 
$
843

 
$
3,051

 
$
2,098

Sales and marketing
1,029

 
771

 
3,255

 
2,062

General and administrative
1,633

 
1,280

 
5,497

 
3,333

Systems development and programming costs
447

 
287

 
1,188

 
758

Total stock-based compensation expense
$
4,188

 
$
3,181

 
$
12,991

 
$
8,251


28


 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Percentage of total revenues:
 
 
 
Professional service revenues
15
 %
 
16
 %
 
15
 %
 
16
 %
Insurance service revenues
85
 %
 
84
 %
 
85
 %
 
84
 %
Total revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Costs and operating expenses:
 
 
 
 
 
 
 
Insurance costs
80
 %
 
77
 %
 
79
 %
 
76
 %
Cost of providing services (exclusive of depreciation and
   amortization of intangible assets)
6
 %
 
6
 %
 
6
 %
 
6
 %
Sales and marketing
7
 %
 
7
 %
 
6
 %
 
7
 %
General and administrative
3
 %
 
2
 %
 
3
 %
 
3
 %
Systems development and programming costs
1
 %
 
1
 %
 
1
 %
 
1
 %
Amortization of intangible assets
2
 %
 
2
 %
 
2
 %
 
2
 %
Depreciation
1
 %
 
1
 %
 
1
 %
 
1
 %
Total costs and operating expenses
98
 %
 
96
 %
 
97
 %
 
96
 %
Operating income
2
 %
 
4
 %
 
3
 %
 
4
 %
Other income (expense):
 
 
 
 
 
 
 
Interest expense and bank fees
(1
)%
 
(3
)%
 
(1
)%
 
(3
)%
Other, net
0
 %
 
0
 %
 
0
 %
 
0
 %
Income before provision for income taxes
1
 %
 
1
 %
 
2
 %
 
1
 %
Provision for income taxes
1
 %
 
0
 %
 
1
 %
 
1
 %
Net income
0
 %
 
0
 %
 
1
 %
 
1
 %
 
 
Three Months Ended September 30,
 
Nine Months Ended September 30,
 
2015
 
2014
 
2015
 
2014
Percentage of Net Service Revenues:
 
 
 
 
 
 
 
Professional service revenues
74
 %
 
68
 %
 
74
 %
 
66
 %
Net Insurance Service Revenues
26
 %
 
32
 %
 
26
 %
 
34
 %
Net Service Revenues
100
 %
 
100
 %
 
100
 %
 
100
 %
Other operating expenses:
 
 
 
 
 
 
 
Cost of providing services (exclusive of depreciation and
   amortization of intangible assets)
28
 %
 
25
 %
 
28
 %
 
26
 %
Sales and marketing
34
 %
 
29
 %
 
31
 %
 
27
 %
General and administrative
13
 %
 
11
 %
 
12
 %
 
11
 %
Systems development and programming costs
5
 %
 
5
 %
 
5
 %
 
5
 %
Amortization of intangible assets
8
 %
 
10
 %
 
8
 %
 
10
 %
Depreciation
3
 %
 
3
 %
 
3
 %
 
3
 %
Total other operating expenses
91
 %
 
83
 %
 
88
 %
 
83
 %
Operating income
9
 %
 
17
 %
 
12
 %
 
17
 %
Other income (expense):
 
 
 
 
 
 
 
Interest expense and bank fees
(4
)%
 
(14
)%
 
(4
)%
 
(13
)%
Other, net
0
 %
 
0
 %
 
0
 %
 
0
 %
Income before provision for income taxes
6
 %
 
2
 %
 
9
 %
 
5
 %
Provision for income taxes
3
 %
 
2
 %
 
4
 %
 
2
 %
Net income
2
 %
 
1
 %
 
4
 %
 
2
 %

29


Three and Nine Months Ended September 30, 2015 and 2014
Total Revenues
 
 
Three Months Ended
September 30,
 
Change
2015 vs. 2014
 
Nine Months Ended
September 30,
 
Change
2015 vs. 2014
 
2015
 
2014
 
$
 
%
 
2015
 
2014
 
$
 
%
 
(in thousands, except percentages)
Professional service revenues
$
99,473

 
$
86,864

 
$
12,609

 
15%
 
$
294,288

 
$
251,999

 
$
42,289

 
17%
Insurance service revenues
568,535

 
469,087

 
99,448

 
21%
 
1,639,305

 
1,337,870

 
301,435

 
23%
Total revenues
$
668,008

 
$
555,951

 
$
112,057

 
20%
 
$
1,933,593

 
$
1,589,869

 
$
343,724

 
22%
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
Key operating metrics: