Description

American Service Group (ASGR) provides managed healthcare services to correctional facilities in the United States.  Currently, it is trading at 5.1x forward EV / EBITDA versus its historical valuation range of 5 – 10x forward EV / EBITDA and has an approximate 18% free cash flow yield on my 2008 FCF estimate.  The stock has fallen by over 30% on mostly non-fundamental issues.  The company operates in a duopoly and new language in the most recent 10Q and conversations with management lead us to believe that they are looking to acquire the #1 company in the space.  Combined, the two companies would have approximately $1.75 in earnings power on an $11.83 stock. 

 

 

Company Description:

 

ASGR provides healthcare services to inmates of prisons and jails.  The company generates all of its revenues from government entities.  None of these revenues are subject to reimbursement or other payment risk.  As a result, we consider this to be a business service company rather than a healthcare company.  Services include on-site medical care, psychiatric care, off-site hospitalization and specialty outpatient care.  Essentially, ASGR is responsible for an inmates healthcare from the time he or she is admitted till the time he or she is released.   Nurses are on-site for 24 hours a day, doctors hold regular hours and there is always someone on call.  The company also provides certain administrative services including the maintenance of medical records, recruitment, scheduling, medical audits and the development of various types of clinical programs.  Prisons are responsible for providing space and supplies.  The National Commission on Correctional Health Care (NCCHC) and the American Correctional Association (ACA) set minimum standards for services. 

 

Industry / Competition:

 

One of the reasons we like this investment so much is the structure of the industry.  It is essentially an oligopoly, and we would argue that it is quickly becoming a duopoly.   Currently, three companies compete for business – ASGR, Correctional Medical Services (“CMS”) and Wexford.  Both CMS and Wexford are private.  Although it is difficult to get exact numbers, we believe that CMS is the number one player in the space and generates approximately $700M - $750M in revenues, ASGR is number two with $570M and Wexford is number three at $150M.   Our research indicates that Wexford is rapidly disappearing.  They recently lost a big contract with the state of New Mexico that was worth $50M in annual revenues, bringing their top line down to $150M.  Out of the $150M, $100M is from a contract with the state of Illinois and $38M is with the State of Mississipi.  Recently, there was an indictment against the Department of Corrections Commissioner of Illinois AND a lobbyist for Wexford, implying this contract win was not on the up and up.  It is likely that Wexford will eventually lose the Illinois contract and has lost other bids (despite the fact that they were the low bid in a few of these) because the industry has its doubts about their ability to deliver quality service.   As a result, it is only a matter of time before the industry is a duopoly.   We firmly believe that ASGR will make a bid for CMS in the near term, and we discuss this in further detail below.

 

Our research indicates that approximately 20% of correctional facilities outsource their healthcare needs to private providers such as ASGR.  The balance of facilities utilize either government sponsored programs or universities.   There has been a (slow) trend towards outsourcing, as ASGR, CMS etc appear to be able to keep costs down better than government / university sponsored facilities (cost savings of 15 – 25%).  However, these companies deal in a very political environment so municipalities do not always do the right thing.     

 

 

Contracts:

 

Contract terms are typically one to three years and most have 90 day outs (by either party).  There are three different types of contracts

1)      cost plus – revenues are based upon how much it costs to provide services to inmates plus a fee on top

2)      fixed fee – revenues are based upon a fixed monthly fee regardless of changes in the size of the inmate population

3)      population based – revenues are based upon a per diem rate based multiplied by the number of inmates

 

Historically, the industry has been extremely competitive and the three primary competitors would often bid using fixed fee arrangements.  This resulted in many unprofitable contracts, of which ASGR has spent significant time over the past few years getting out of.  Today, players are much more rational.  Bids are almost exclusively cost plus or population based and almost all have caps and / or limits on costs so as to prevent negative margins.  When fixed fee bids are made, they are a maximum of one year contracts and usually have 30 day outs.   ASGR has slightly less than 10% of their contracts that contain no limits (none of which have longer than a one year term). 

 

The company’s biggest contracts are with the Pennsylvania Department of Corrections (expires 9/08) and Rikers Island.  The Rikers contract was set to expire at year end and the company put out a press release on September 25^th saying that Rikers intends to extend the contract through 12/31/10.  This removed the biggest short term risk associated with the story.

 

Cap Structure / Valuation:

 

Fully diluted shares:       9.5M

Price:                            11.83

Market Cap:                  $112M

Debt:                            $10M

Cash:                            $10M

Enterprise Value:           $11M

 

2008 EBITDA estimate (assuming no new business): $22M

EV / EBITDA:  5.1x

 

2008 FCF estimate:        $20M

2008 FCF yield: 18%

 

Recent Events / Decline in Stock Price:

 

From July 31^st to August 16^th the stock dropped from $17 to $10, a decline of 40%+ and now sits in the high $11’s.  During this time period there was one fundamental negative development and a significant non-fundamental reasona that resulted in the severe decline.

 

From a fundamental perspective, ASGR lost its contract with the State of Alabama.  This contract was worth $50M on an annual basis and approximately 8% of revenue.  ASGR was the incumbent and Alabama put out an RFP when the contract was expiring.  ASGR, CMS and Wexford all submitted bids and ASGR was the low bid – Alabama revealed the exact dollar amounts of all bids to all three parties.  The next day the state claimed that they “forgot” 1400 inmates were being transferred from Louisiana back to Alabama and asked the companies to rebid (after revealing the size of the initial bids).  The second round of bids came back and Wexford was the low bidder.  However, Alabama didn’t believe that Wexford could adequately service the account and went with CMS, who was the second low bid by a fraction.   This bidding process reveals some of the difficulty (and risks) associated with an investment in the space.

 

Theoretically, the loss of the Alabama contract should have cut 10% from ASGR’s stock price, all else being equal.  However, there were darker forces at work.   We have confirmed that Healthinvest Partners, the company’s third largest shareholder was facing a cash crunch that many other funds faced in the beginning of August.  They sold their shares in the open market without regard to price, and it appears that a few others might have followed suit.  Over the course of several weeks approximately 25% of the float traded hands.   As a result, what should have been a 10% move in the stock resulted in a 40% move. 

 

Catalysts:

 

1)      New contract wins:   ASGR is in an enviable position today.  They have no major contracts out for rebid for the next 12 months.  The only contract of size is Alameda County (CA) which is a $20M contract (on approx $570 - $600M base) which is up for rebid in the spring.  On the contrary, CMS, the company’s largest competitor has 40% of their contracts out for rebid over the next six months!  These contracts include:

a.       New Jersey Department of Corrections ($110M)

b.       West Virginia Department of Corrections ($40M

c.       State of Michigan ($100M)

d.       Idaho Department of Corrections ($30M)

 

Total $280M on $700 - $750M revenue base = 37 – 40% over six months.  My estimates on revenues / valuation for ASGR does NOT include any potential wins.  It is likely that they will win something.

 

 

2)      Likely purchase of CMS (combining #1 and #2 in the industry):   This is where the story gets very interesting.  ASGR has made a run at CMS two times in the past.  CMS’s primary investor is Madison Dearborn.   CMS is Madison Dearborn’s last investment out of one of their funds.  This fund is set to expire in February of 2008 and CMS is the only portfolio company that remains – so Madison has to decide how to liquidate the position.   If you read through ASGR’s last few transcripts you will see that they have been talking more prominently about acquisitions.  If you get them on the phone you will hear them talk about consolidation in the industry and if you read between the lines, you will see that they really want to purchase CMS.    Additionally, the company added language to their most recent 10Q that was never there before:  The most recent 10Q says: “The Company has not paid any cash dividends and expects for the foreseeable future to retain all of its earnings to finance the development of its business. “  In the prior 10Q’s, that statement includes the words “to finance the development of its business and continue its stock repurchase program.”  The company has essentially suspended its repurchase program despite the fact that they purchased 20% of their stock over the past few years at levels 35% above where the stock is currently trading.   Further proof lies in the company’s Q2 press release which says: “Over the near term, the Company intends to consider acquisition opportunities within the correctional healthcare services industry that it believes may be available during the next few quarters.”  Since CMS is private it is difficult to get financials.  However, we have performed some analysis based on what information we had and estimates of margins based on our knowledge of ASGR.  We believe that it would be possible to shave 15% of the SG&A off the combined company.  Assuming borrowing, interest costs and the SG&A savings we estimate the combined entity would have (conservatively) between $1.60 and $1.80 in earnings power.  Furthermore, the pricing environment should become much more benign.  If pricing were to improve and they could generate 1% additional margin improvement we would be looking at close to $3 in earnings power (we are not going there but just use it as an illustration of the potential combination).  A combined company would have revenues of $1.3B with its closest competitor at $150M.  It is our opinion that ASGR would receive regulatory approval because there are no barriers to entry to provide these types of services to correctional facilities. 

 

3)      Increased share buybacks:   The company has purchased approximately 20% of its shares over the past two years at prices that are 35% above where the stock is trading today.  If the CMS acquisition does not materialize we would expect the company to borrow against its credit facility and aggressively repurchase an additional slug of stock.

 

 

Risks:

1)      HMOs:  The State of Michigan has recently broken up their state into five regions which will be bid on separately.  Their initial request for RFPs requires the provider to be an HMO.  So far, there have been no bids.  In our opinion, HMOs would have a difficult time managing prison / jail facilities for several reasons:

a.       HMO cost structures are much different and their margins are significantly higher than a company such as ASGR.  It would be difficult to offer services at a competitive price.

b.       ASGR and other companies in the space have procedures in place for dealing with violent criminals – this is an extremely important aspect of the services they offer.  HMOs have never done something like this.

 

2)      Pricing: Pricing is and always will be competitive.  We are hopeful the environment will change if ASGR and CMS combine.

3) Loss of contracts:  This is probably the biggest risk.  Contracts typically have one to three year terms.  As the Alabama example (above) highlights, there is always a risk that ASGR could lose contracts on a year to year basis.

Catalyst

• Probable acquisition of CMS, combining the #1 and #2 companies in the space
• New business wins – ASGR’s primary competitor has 40% of their business up for rebid in the next six months
• Valuation at historical trough levels with 18% free cash flow yield