Elie Rosenberg is a value investor based out of Dallas, Texas. He is the founder and editor of valueslant.com, a site dedicated to value investing research and analysis.
Providence Service Corporation (PRSC) is a quality business whose stock is being depressed by misplaced headline risk relating to strained state government budgets and Medicaid reimbursement. The reality is that in a tight money environment PRSC can gain market share because they provide federally mandated services with low cost delivery models, and their strategy of handling government contracts with sustainable margins will enable them to maintain profitability. One can acquire this business with recurring revenue, minimal capex requirements, and strong free cash flow at 4.3X EBITDA and 8.5X earnings, and it is even cheaper in light of locked in contracts that will boost revenue going forward. I think the stock has 100% upside potential in the next 18 months based on a conservative earnings scenario, and substantial growth opportunities could provide even greater returns.
| Ticker | PRSC |
| Price as of 7/11/2011 | 12.31 |
| 52 Week Range | 11.34-18.27 |
| Shares Out (MMs) | 12.96 |
| Market Cap (MMs) | 159.5 |
| Enterprise Value (MMs) | 271.9 |
| P/E (TTM) | 8.5 |
Company History
PRSC was founded in 1996 by CEO Fletcher McCusker as a provider of in-home government sponsored social work counseling. At that time most government social services were delivered directly by the government in institutional settings. PRSC believed those services could be provided at a lower cost and with better outcomes if they were outsourced to a private firm to perform them in clients’ homes. PRSC has grown through steady high single digit organic growth, as well as a series of small tuck-in acquisitions from 2002-2008.
In 2007, PRSC expanded into a new line of business with the acquisition of Logisticare, a provider of non-emergency medical transportation for recipients of government sponsored healthcare. At a $220 million purchase price this was easily PRSC’s largest acquisition and it more than doubled revenues.
The transaction was almost entirely debt financed and turned PRSC into a highly leveraged company heading right into the recession. In mid to late 2008 state governments were caught off guard by the economic downturn and their budgets were in disarray even after the start of their fiscal year in July. They cut back on quotas with PRSC and delayed implementations of new contracts. Two weak quarters in Q3 and Q4 08 brought PRSC very close to violating their debt covenants and the stock dropped from over $30 to $1.
Business quickly picked up for PRSC and 09 and 10 were strong years for the company, with strong cash flows providing the opportunity for substantial deleveraging.
Business Overview
Social Services
Home based counseling is the main revenue stream in this segment. There are two broad levels of counseling offered. Basic counseling on topics such as anger management, substance abuse prevention, and family dynamics averages 5 hours a week. More intensive counseling is also offered for 20+ hours a week for clients suffering from severe behavioral health issues that in many cases might otherwise need to be treated with institutionalization. Home counseling accounted for about $250 million, or 28%, of company-wide 2010 revenues.
Smaller divisions within this segment offer foster care training and supervision (4% of 2010 revenues), workforce counseling (4%), administrative support for not-for-profit social services entities (2%), and social services for schools (1%). The Social Services division in aggregate accounted for 39% of PRSC revenues in 2010.
PRSC currently serves almost 60,000 social services clients in 42 states. This segment has over 1,000 contracts with governmental entities, mainly on the regional and local level. The vast majority of their clients are Medicaid recipients and thus eventually reimbursed by state governments.
70% of the revenues in this segment are contracted on a per hour basis, 20% on a cost plus basis, 7% (one large contract) on a per client fixed rate basis, and the rest is administrative support services, which are generally contracted on a percentage of client revenues.
This segment is run out of 273 small leased field offices generally located in strip malls. Most of the sales and marketing is done by the field offices to leverage relationships with local government entities.
Non-Emergency Transportation
This segment (61% of FY 10 revenues) facilitates non-emergency transportation (NET) to medical appointments for recipients of government sponsored health care benefits (mainly Medicaid). The NET segment, operating under the Logisticare name, does not directly own or operate any transportation vehicles. Rather it acts as a logistical coordinator and outsources the transportation to local transportation companies. Logisticare typically will operate a call center to take calls from clients and schedule pick ups, coordinate billing, and oversee service quality.
Almost all of the contracts in this segment are capitated, meaning PRSC is paid a fixed per-member per-month (PMPM) rate regardless of the level of service provided. In this segment PRSC targets state-wide or large regional contracts, with most of the funding coming from state Medicaid reimbursement.
Corporate Strategy
PRSC’s corporate strategy is straightforward-
Provide differentiated, low cost, effective delivery solutions for government sponsored social services and non-emergency transportation:
Social Services- PRSC can see six social services clients in an at-home setting for the government’s cost of providing care for one client in an institutional setting. Another advantage of PRSC’s in-home model is that it alleviates the large percentage of no shows to Medicaid behavioral health appointments that lead to gross inefficiencies.
NET- The standard model for NET prior to PRSC (and still employed by 30 states) was to provide Medicaid clients with vouchers for public transportation or taxis. This an inefficient, hard to monitor, and easily abused system. PRSC’s brokered model typically saves states 50% in prior year costs upon implementation. Additionally, the PRSC NET model also helps reduce no shows by monitoring whether patients actually arrive at their medical appointments.
Transparently manage margins for profits that are acceptable to government payers, thereby securing solid long term relationships:
PRSC has realized since its inception that health care outsourcing providers do not have any pricing power with government payers. Fat margins will only last until the government recognizes that they can pay less and their providers will still remain in business. PRSC chooses to not play games surrounding margins and voluntarily provides their payers with service at a sustainable margin. This has led to an excellent reputation among payers as evidenced by PRSC’s contract retention rate.
Drive volume to grow profits despite slim margins:
As the CEO likes to say, PRSC is a volume story not a margin story. They are resigned to flat rates in perpetuity and aim to grow profits through volume increases. There is still room for substantial growth on both the social services and NET side, boosted by the unique set of circumstances surrounding Medicaid and state budgets.
Control expenses to maintain margins:
To remain a low cost provider, PRSC has to tightly control expenses. PRSC employs asset light, variable cost models that can shrink or grow quickly in response to volatility in government funding. There are no large sunk costs in buildings or vehicles that can lay fallow if funding contracts. Payroll is 70% of expense in the social service segment, with much of that tied to performance benchmarks that only grow expenses with increased volumes and scale back expenses if volumes are hit. On the NET side the major cost (84% of expenses) of outsourced transportation is only booked as needed to serve clients. The strong revenue visibility provided by long term or recurring contracts also helps enable expense management.
Competitive Environment
On the Social Services side, contracts are up for renewal yearly, but are not usually competitively rebid and are very sticky. Remarkably, PRSC has only lost one contract in Social Services since 1996 (they now have over 1,000 contracts). There does not appear to be any intrinsically high switching cost for the government, so this statistic is a testament to PRSC’s level of service and transparency surrounding their margins.
Given the tight Medicaid budgets of recent years, social services contracts are typically renewed at the existing rates plus a small (typically 1-1.5%) cost of living adjustment. With the ever growing Medicaid rolls, these contract renewals often come with volume bumps as well. PRSC also drives organic growth by expanding existing government relationships into adjacent geographies or new lines of counseling.
PRSC receives funding through appropriations at the state legislature level, which are usually set by the end of June (the states’ fiscal year runs from July to June). With exploding Medicaid rolls, payers are almost always asking the legislature for an increase in the amount allocated to PRSC social services contracts, and usually they receive only a portion of what they ask for. PRSC can be basically guaranteed that they will see the entire appropriation as revenue, because payers will lose their appropriation base for the next year if the entire earmark is not used. Thus PRSC has the convenience of almost complete revenue visibility for the coming year once the state budgets are finalized in June.
As an estimated 60% of Medicaid sponsered social services are still delivered in institutional settings, PRSC is largely competing against a legacy delivery model that is both less efficient and higher cost. Within the in-home providers, PRSC mostly competes with small local not-for-profit entities. PRSC appears to be the only national provider that focuses on in-home mental health services, but there are some national competitors in some of the smaller niches like a division of Res-Care (mainly a senior care company, recently bought out) in workforce and National Mentor in tutoring.
On the NET side, Logisticare targets statewide or large regional contracts that typically run four to five years and can generate upwards of $90 million annually. Logisticare invented the transportation broker distribution model for Medicaid, and they won the first 19 contracts awarded by the states. Competition has picked up in the space, but Logisticare has still won five of their last eight bids. Contracts on the NET side are sent out for rebid upon expiration, but Logisticare has only lost one contract since being acquired by PRSC- the Missouri contract last year.
There are variety of factors that are used in grading bids, with price only being one of them. Logisticare is competitive on price, but they do not think they are typically the lowest cost bidder in terms of the absolute PMPM rate. They score highly on experience, technical know how, and financial strength components with a reputation for being able to handle large contracts. For example, a recent bid for Wisconsin weighs technical factors such as scope of work and experience at 75% and cost at only 25%. Logisticare won the contract by coming in first on the technical factors while coming in third of the three finalists on the cost component.
The competition on the Logisticare side has historically been mom and pop local and regional providers. Logisticare feels they have an advantage in bidding for larger contracts due to their size and experience. However, several large players have emerged in the space, most notably privately held Medical Transportation Management and American Medical Response (a segment of now privately held Emergency Medical Services which was bought out in February). But Logisticare still has excellent competitive position as the clear market leader with the most experience running large state-wide contracts.
The low margins in both segments may be one reason why there has not been substantial national competition in either space (although competition is rising on the NET side as noted). A competitor would have to spend the time to build a large book of business before seeing substantial profits and would have to excel in tightly managing expenses from day one to remain competitive.
The Medicaid Situation
The overhang on PRSC stock is primarily the mistaken perception that their revenues and/or margins will be fatally harmed by state government budget turmoil. The argument is that states pay Medicaid, PRSC gets the vast majority of their revenue from Medicaid, states are in trouble, and thus PRSC is in trouble. The reality is that PRSC is actually very well positioned in relation to Medicaid and it is hard to envision a plausible Medicaid budget scenario in which they do not benefit in the next several years.
The key to Medicaid budget issues is the federal/state relationship. Medicaid is a partnership between the federal government and the states. The states operate Medicaid programs and are the direct payers of Medicaid reimbursement. The federal government provides matching grants to the states of 50 to 80% of their Medicaid spend (known as FMAP-Federal Medical Assistance Percentage) provided that they operate their Medicaid programs within federal guidelines.
This partnership has created interesting dynamics as state budgets have tightened while the Medicaid rolls continue to explode (with the current nationwide number estimated at 58 million). Many states would like to reduce the amount of money they spend on Medicaid. The easiest ways to do this are to either limit Medicaid eligibility to fewer people or cut back on Medicaid benefits. State do not have much flexibility to pursue either option without running afoul of federal requirements that need to be met in order to receive matching dollars. And not receiving the FMAP payments is not a feasible option for any state as it is such a sizable amount of support at a time when it is sorely needed.
The states now have a predicament. They have to maintain essentially the same level of Medicaid benefits to a growing number of enrollees in order to keep getting FMAP dollars. But they have to do so at a lower cost to balance their budgets. Enter PRSC.
Both of the services that PRSC provides- social services and non-emergency transportation- are federally mandated Medicaid benefits that states cannot eliminate. PRSC gives the states solutions to provide these services at a dramatically lower cost.
The new health care act provides additional financial incentive to the states to pursue in-home care delivery like PRSC’s social services. The federal government will provide an increased 90% matching rate (in comparison to the standard which averages 60%) to incremental funds allocated to in-home solutions. 60% of Medicaid funds are still spent on institutional care so there is still a huge amount of business that can be reallocated to the in-home model. PRSC is optimistic that they can gain market share by continuing to pitch the states that money is better spent when reallocated to in-home care.
The current situation is neatly summed up in a February letter from Secretary of Health and Human Services Kathleen Sebelius to state governors. The governors have asked whether she can waive the “maintenance of effort” requirements that require states to maintain federally defined Medicaid eligibility standards to qualify for matching funds. Sebelius responds that she cannot legally waive this requirement, but that there are other methods of lowering costs that states can pursue. One approach that she mentions is in-home care, noting the increased financial incentive now being offered by the federal government.
The one mode of recourse for states within federal guidelines is to cut Medicaid provider reimbursement rates. So even if states would not cut back on PRSC services they can still attack PRSC’s reimbursement rates. PRSC has not seen extensive rate cuts in the past few years despite all of the turmoil. Things could change going forward, especially in light of the June termination of the enhanced federal matching dollars connected to the economic stimulus package that have provided the states with an additional $100 billion since 2009. Six states have announced across the board provider rate cuts for the coming fiscal year.
Several factors mitigate the rate cut concern. Management thinks their sustainable margin approach is paying off in that payers recognize they are already getting a fair deal and that rates need to be maintained for their service levels to be stable. PRSC is already on the low end of the spectrum in terms of cost to states, so states would presumably not want to disincentivize them from taking further business.
Additionally, states pursuing across the board rate cuts have been met with significant legal challenges. For example, the 10% across the board cuts to Medicaid reimbursements in California have been challenged on the grounds that physicians will not be willing to treat Medicaid recipients at the reduced reimbursement levels. The legal argument is that these cuts leave Medicaid recipients without “reasonable access to care”, which is a state requirement.
Finally, even if rate cuts are enacted, PRSC has ways to cope. PRSC did deal with a few steep rate cuts in 2008, most notably in California (where the cut was eventually stalled in court). In that case, PRSC made up for the cut with increased volume as naturally a state in such dire financial straits was looking to shift more volume to a lower cost provider. Also, PRSC is able to manage margins in a rate cut environment by dialing back variable wage expense.
On the horizon is the large catalyst of Medicaid eligibility expansion in 2014 mandated by the Affordable Care Act. It will raise the poverty level to qualify for Medicaid to 133% of the poverty line and make an additional 16 to 18 million people eligible for Medicaid. Estimates vary as to how many of those newly eligible will actually enroll in Medicaid, but the Congressional Budget Office estimates 10 million in 2014 rising to 16 million by 2016. Even at 10 million that would be a 17% jump in national Medicaid enrollment. The institutional treatment infrastructure would not be able to handle such an abrupt jump, so this would be a boon to in-home care providers such as PRSC and would also raise their NET enrollment.
The act also includes an early adopter clause, which allows states to adopt the expanded Medicaid eligibility prior to 2014 and receive enhanced federal government support. So far only Connecticut and Washington D.C. have done this, but now that efforts to repeal the act appear stalled more states might adopt early for the increased federal aid.
Financials Analysis
(2008 net income numbers include asset impairment charge)
Revenues
Social Services
The social services segment has historically averaged 7-9% organic growth, driven mainly by the rise in the Medicaid census (the number of Medicaid clients served). Growth slowed in 2010 as the client census actually declined from 62,000 to 58,000. The core Medicaid census was up, while the overall census decline was attributable to a decline in workforce development. The foster care segment has also seen declines in the past few years as states look for lower cost alternatives. The segments outside the core Medicaid business do not have the unique dynamics of the Medicaid business and are much more susceptible to state budget pressures. However, they represent only about 10% of revenues. Management expects the declines in the non-core business lines to stabilize and to be able to show overall growth in the Social Services segment in the mid to high single digits driven by a continued rise in the Medicaid census.
The potential market for Medicaid in-home social services is enormous. An estimated 13%, or 7.5 million, of Medicaid enrollees use mental health services. If we assume that 60% are still being treated in institutional settings then that is 4.5 million people that can be potentially moved to in-home care. Not all of those people are eligible for in-home care, but clearly the number that is eligible is many multiples of PRSC’s current 60,000 census.
Non-Emergency Transportation
The NET segment has seen tremendous growth since the 2007 acquisition. It has been driven by both new contract wins and growing Medicaid enrollment under existing contracts. Last year was a particularly strong growth year for existing contracts. The rise in unemployment combined with a new rule making it easier for the unemployed to join Medicaid greatly expanded the Medicaid census.
Two large contracts are up for rebid this year- Virginia at 13% of NET revenues, and Pennsylvania, which I estimate at about $30 million or 6% of NET revenues. They received an “intent to award” for the Virginia contract at the beginning of June. They are still waiting to hear about Pennsylvania as the contract is not up until December.
In 2011 Logisticare will continue their geographic expansion in NJ, which is expected to bring in $20 million in incremental annual revenue. And in July they will start up in Wisconsin, which is a new three year contract win. That contract appears to be worth about $42 million annually based on the award document.
The major new opportunity for the segment is Texas, which is implementing an outsourced model for the first time. The RFP was sent out in August of last year and the award had been long delayed. On June 3, Texasannounced a tentative award to Logisticare for one of the two regions put out to bid for a four year contract. PRSC cannot publicly announce the award until it is finalized. Logisticare won the Dallas region, which I estimate to be about a $40 million a year contract. The PRSC CEO has stated that he thinks the combined Texas contract is for $100 million, and the Dallas region is about 40% of the total eligible client base (the other region being the slightly larger Houston region). That would come to a PMPM of about $4.30, well below the Logisticare average for 2010 of $5.45, so $40 million might be a conservative estimate.
Nevada is another outstanding bid where the state is moving to a brokered model for the first time. The award should be announced sometime in July, and I estimate it is a $15 to $20 million opportunity.
There are still 30 states that could move to an outsourced brokered NET model, which is a multi-billion dollar opportunity. Several states are in active exploration of switching. As the market leader Logisticare clearly has a large pipeline of potential business moving forward.
Margins
EBIT margins were in the 8-9% range prior to the Logisticare acquisition, and have been in the 6-7% range since (leaving aside the unusual circumstances of 2008) as Logisticare has historically been a lower margin business than Social Services.
PRSC expects to receive flat rates for the foreseeable future in both Social Services and NET, and although there has been much talk of rate reductions they have not actually seen them in their Medicaid business in the past several years. They have guided for both segments to hit 8.5% EBITDA margins (including corporate level overhead allocation), which would be lower than the historical average for social services and slightly higher for NET.
The flat rate environment leaves PRSC to manage expenses in order to maintain margin. This is fairly straightforward on the social services side where the main expense is payroll that can be aligned with client service volumes. However, last year was an unusually poor year for social services margin wise (4.8% fully allocated EBITDA margin) due to wage increases and bonuses to field workers after a wage freeze in 2009, reclassification of some insurance related costs from the SG&A line to the direct expense line, and some bad debt write offs. They should be able to return to more historical margin levels within the next year- Q1 2011 EBITDA margins already showed an increase to 7.3%.
Margin management is trickier on the NET side where revenues are fixed based on a PMPM contract and expenses are variable based on actual client travel volumes. Margins fluctuate based on client utilization, which can be driven by a number of factors such as:
- Age of contract- Newer contracts tend to have lower utilization rates as clients begin to learn about the new service
- Seasonality- Poor weather tends to reduce utilization in the winter months.
- Gas prices- With higher gas prices, more people are motivated to use the NET service instead of drive
2010 was a record year for Logisticare margins with an EBITDA margin of 10%. That was due to the large volume of low utilization new business added during the year,stabilization in gas prices, and some periods of poor weather. For the coming year, utilization is expected to normalize at a higher rate and gas prices will likely be more volatile. In addition, Logisticare plans to voluntarily manage margins downward by providing more services for the same rate. This is part of their long term strategy of ensuring consistent margin expectations to maintain government relationships. Due to these factors management is guiding for EBITDA margins in the NET segment to decline to 8.5%.
In the first quarter of 2011, Logisticare saw higher than anticipated utilization on their new business in New Jersey, which squeezed EBITDA margins under budget to 7.5%. Logisticare is able to renegotiate their rates if higher utilization is expected to persist, as is the case presently in New Jersey. The rates will be reset on July 1. However, the low rates remain through Q2 and the company revised Q2 guidance 5-7 cents lower.
G&A expense, which is about 40% lease expense, has been held basically flat in the past three years even as revenues have grown from $692 million to $880 million. It seems like there are benefits to scale on this line, although there are none on the segment level. As sales continue to grow this scale should help alleviate some of the margin pressure on the segment level.
Cash Flow
One of the most attractive attributes of PRSC is the free cash conversion due to the very minimal capital requirements of the business. The business requires literally zero additional working capital to grow sales (net working capital numbers in the chart exclude cash and short term debt). Working capital is actually down from prior to the Logisticare acquisition in 2007 when the company did only $285 million in sales. The Social Service segment requires minimal working capital due to being a service business with no inventory. And the NET business runs on negative working capital because it is paid in advance at the start of each month.
Capex requirements are also very minimal. Capex jumped in 2010 due to a one time $3.5 million spend to buy an office building adjacent to corporate headquarters at a distressed valuation that will be used to house their IT operations. This will save on rent over time. But backing out that spend, capex has averaged $5.1 million over the past the past 3 years.
The asset light model is evident in the cash from operations and free cash flow (CFO-capex) numbers, with free cash flow well in excess of net income. Depreciation and amortization is inflated due to the allocation of acquisition purchase prices to intangibles such as customer relationships and management contracts. D&A runs about $13 million a year while maintenance capex is $5-6 million.
Capital Structure and Allocation
PRSC carries a total of $170 million in debt- a $100 term loan refinanced in March to bear LIBOR plus 2.25-3.00%, and $70 million of convertible notes paying 6.5%. PRSC has $57.6 million in cash for net debt of $112.4 million.
The old term loan had an interest rate of LIBOR+6.5%, so the new financing will save at least several million dollars a year in interest expense. The new financing also includes a $40 million revolver and the option to increase the credit facility by an additional $85 million. The credit facility comes due in March 2016. The term loan is subject to mandatory amortization of 10% of the loan balance in the first two years, 15% in the third and fourth year, and the remaining balance in the fifth year.
The convertible notes were issued as part of the Logisticare acquisition financing in November 2007 and come due in May 2014. They convert to common shares at $46.90.
The major use of cash the last several years has been to reduce debt after levering up for the Logisticare acquisition in 2007 and getting caught in 2008 in danger of violating debt covenants. PRSC has paid down $76 million in debt in the last 3 years.
Having generated $64 million in TTM EBITDA, PRSC is fairly safe with $112.4 million in net debt, although they will keep paying it down with the mandatory amortization.
Shareholders have asked management why PRSC is keeping so much cash on their balance sheet earning nothing while continuing to pay interest on the debt, especially in light of the fact that management has stated that they only need between $10 and 20 million in cash to run the business. Management has responded that they like to keep at least $50 million in cash on the balance sheet for bidding purposes. Cash balances are looked upon favorably by government payers to indicate the ability to implement large contracts. They also have said they want to keep some cash available to finance a possible acquisition or tender some of the outstanding notes.
After laying off acquisitions in the past two years, management has stated that they are looking at both small tuck in acquisitions or a larger acquisition in the home healthcare space. Companies in the home health space have run into trouble with fraudulent billing issues as well as the fact that the government will no longer tolerate their high EBITDA margins. Government payers have asked PRSC to move into home healthcare and employ their sustainable margin model. Home healthcare is a similar business model, but there is more competition with bigger players than in the social services space. PRSC has been looking at entering this space for over a year but is waiting for deal valuations to improve. Acquisitions are being priced off of TTM EBITDA levels that are probably not sustainable going forward.
Another major opportunity for PRSC is the potential outsourcing of military social services. This is currently run by the military in institutional settings with high no-show rates. PRSC has been in talks with the military about employing PRSC’s in-home model. However, this has been talked about for over a year so I am not sure much progress is being made.
Another sensible option with the stock so depressed is a stock buyback. Under the new credit agreement this can be done without senior lender agreement, and management has said it is under consideration.
Valuation
PRSC is a very cheap stock on trailing twelve month numbers, and even cheaper on what I think they will be able to do over the next one to two years with already acquired new business. Current valuation numbers include a P/E of 8.5, EV/EBITDA of 4.3, and a free cash flow yield of 19.9%.
PRSC is dramatically undervalued to what I think is a conservative normalized base scenario, which should play out through 2012:
Assumptions:
- Revenues grow $100 million over 2010 to $980 million. The incremental revenues appear to be locked in on the NET side alone- $20 million in New Jersey, $40 million in Wisconsin, and $40 million in Texas.
- I will not explicitly assume any growth in Social Services, which management thinks should resume its perennial 5-10% growth. Realistically that segment should see at least some growth, but I will leave it as a buffer in case there is a contract loss on the NET side or issues with rate cuts in Social Services. I will also not assume any organic client census growth within existing NET contracts (aside from NJ), while realistically there should also be at least a few hundred basis points of growth there as well.
- 7.5% EBITDA margin, below management guidance of 8.5% and 2009 and 2010 margins of 8.3% and 8.0%. This should account for any utilization issues with Logisticare and some rate deterioration.
- I assume the current capital structure with 4% interest on the term loan (it is probably 3% right now). As they continue to slowly pay down the debt more value will transfer to the equity.
- I take the company’s guidance of a 42.5% effective tax rate due to an increase in revenues in higher state tax states.
There are no great comps to compare multiples for PRSC. The home health companies are probably the closest comps for the Social Services segment, but they are also trading around the same depressed multiples. Part of the overhang on PRSC is that they are lumped in with the home healthcare companies. But in home health there are issues with fraudulent billing and their margins are more than double that of PRSC so there is much more for the government to justifiably attack. Beyond that, the NET segment of PRSC, which is a majority of their revenues, has different characteristics.
The historical multiples for PRSC are also not all that relevant. PRSC traded like a growth stock (which it was) at 20-30X earnings prior to the recession.
I think that if PRSC can continue to report revenue growth with stable margins then the Medicaid/state budget crisis overhang will at leas partially lift and PRSC will receive modest multiple expansion. This is especially likely given the intrinsic quality of the business (revenue visibility, cash generation, minimal capex etc.). Here is what we get assigning modest multiples to the above earnings scenario:
In short I think the stock is worth $23-25 without assigning any value to the substantial growth possibilities of both business segments.
What is a realistic worst case scenario? It is hard to see how PRSC does not have at least some modest top line growth off of 2010 due to the new NET contracts. Let’s assume they somehow only add on $50 million to the $880 million of revenue in 2010 (remember they should have at least $60 million of incremental revenue locked in from active contracts with New Jersey and Wisconsin) and EBITDA margins fall from 8% in 2010 to 5%. PRSC would still be doing $47 million in EBITDA and earning $1.05 a share for multiples of 5.8X EBITDA and 11.8X earnings. So even in a worst case scenario I think PRSC is about fairly valued. The current valuation assumes a very pessimistic forward scenario somewhere along these lines, which should provide downside protection.
Consensus View
The consensus view seems to be that PRSC is doomed to stagnant revenues and declining margins because of their exposure to state budgets. It also hasn’t helped the stock that management guided for EPS in 2011 to come in lower than 2010 and then lowered Q2 guidance after Q1 due to the short term margin issues in New Jersey. Management has been very cautious with their guidance (basically saying as much in the Q&A on the last two conference calls). Analysts also have not yet factored in the Virginia contract renewal and the Texas contract win.
Timeline/Catalysts
I think over the next 18 months that PRSC can prove the staying power of its business model by continuing to win market share with stable margins. Specific catalysts:
- NJ rate reset starting in Q2
- Reporting results of June contract renewal cycle
- Releasing full year 2011 guidance with Q2 earnings
- Announcement of Texas contract
- Affordable Care Act sticks/early adoption by some states
- Continued deleveraging and cash build on balance sheet
More speculative potential catalysts include: stock buyback, entry into home healthcare, military contract.
Risks
Medicaid/State budget cuts- I have laid out a case for why I think this is not an issue. Of course anything is theoretically possible and we might see some vast structural change to Medicaid such as states being given more control to set funding guidelines or social services or NET being dropped from the benefits list. But such proposals do not appear to be under serious consideration.
Customer concentration- The NET segment has large individual contracts, and the top five payers constitute 49% of revenues. However, Logsiticare has only lost one contract since being acquired by PRSC, and they were able to make up the volume quickly with new contracts. I think the excellent retention rate and pipeline of potential new business is enough to mitigate the concentration risk. On the Social Services side the client base is more diversified.
Repeat of late 2008- The recession was a perfect storm for PRSC in that it hit at mid year right as states were preparing budgets and sent payers into disarray. The resulting slowdown in government bookings combined with the high leverage of PRSC proved to be an almost fatal mixture. But in the end business normalized after two quarters. Since then PRSC has signficantly reduced their leverage and will continue to do so. They should be able to survive a two quarter slowdown.
Fraud risk- This has often been an issue with private Medicaid and Medicare billers. The risk is mitigated somewhat in the case of PRSC because they do not directly refer patients to their services. All of the patients have been approved by caseworkers outside of the company. Another point to consider is that the business model of PRSC is built around sustainable margins tolerable to government payers, so presumably there is less of an incentive to cheat the system as well as less scrutiny by the government.
Growth risk- This would come primarily from management pursuing a large acquisition in another vertical like home healthcare. I would like to seem them get the stock price up before pursuing a large deal. But even if they do, management seems committed to not overpaying and will only pursue opportunities to employ a similar business model. Additionally, management is probably wary of relevering the company to 2007 levels. They have said an acquisition in home healthcare would probably be in the $20-50 million range that would just give them a foothold in the market from which they could then grow organically.
Disclosure: I own shares of PRSC.
