PROVIDENCE SERVICE CORP PRSC
November 28, 2011 - 9:55am EST by
bentley883
2011 2012
Price: 11.04 EPS $1.16 $1.65
Shares Out. (in M): 12,994 P/E 9.5x 6.7x
Market Cap (in $M): 144 P/FCF 5.1x 4.8x
Net Debt (in $M): 95 EBIT 39 49
TEV ($): 239 TEV/EBIT 6.1x 4.9x

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  • Magic Formula

Description

Providence Services Corporation

An Attractive “Magic Formula” Stock with a Free Call Option on Future Growth

Overview: PRSC is a classic “Magic Formula” stock, with a free call option on future growth. The shares have a number of appealing characteristics, including:

  • an attractive and disruptive, asset light, high return on tangible invested capital business model with healthy cash flow dynamics.
  • leadership position in both its major market segments with some scale benefits.
  • significant near and long-term growth opportunities (which in the current economic environment stands out).
  • positioned correctly in the current health care debate as part the solution (as opposed to part of the problem).
  • knowledgeable, shareholder friendly management team, that appears to be a good allocator of capital.
  • attractive valuation on a number of metrics (i.e. low P/E & PEG, attractive FCF/EV yield and significant discount to private market valuations), and one which I believe is not giving any value to one of the Company’s two businesses.
  • a number of potential near-term catalysts associated with pending awards in the transportation services business, which if won, could result in significant growth and upside to consensus EPS forecasts.

Key Statistics

Symbol: PRSC

Date: 11/28/11

Price: $11.04

52-Week Range: $8.35-$18.00

Shares Outstanding (000): 12,994

Average Volume: 45,528

Market Capitalization: $143.5 million

Enterprise Value: $238.6 million

2012 Revenues: $984.6 million

2012 EPS: $1.65

2012 P/E: 6.7x 

Profile: The Company provides a portfolio of Medicaid funded services to low income individuals and families. PRSC was founded inArizona in 1996 to take advantage of the transition in the market to providing social services in a home and community based setting and away from large institutions. From the Company’s beginnings the CEO, Fletcher McCusker, established PRSC with the vision that a number of these services could be provided more economically and effectively in a home environment than in a high-cost legacy institutional setting. During the ensuing years, the Company expanded to provide services in roughly 33 states as well asWashingtonDC andBritish Columbia via 550 contracts covering more than 60,000 clients. In 2008, the Company made a transformational, but ill-timed acquisition of LogistiCare Services, expanding into the non-emergency medical transportation (NEMT) services market. Following a period of turmoil in 2008, the NEMT business has expanded rapidly with contracts now covering roughly 10 million individuals in 15 states. Today the Company derives about 39% of revenue and 25% of profit from social services and about 61% of revenue and 75% of profit from the NMET services business. In the social services business the majority of revenue are provided under fee-for-service agreements with various Medicaid supported organizations on an hourly or monthly basis. In the NEMT business, revenue is provided under contracts with various state Medicaid agencies on a per member per month capitated basis. The social services contracts are normally renewed annually while contracts in the NEMT business are normally 3-5 years in duration.

Key Investment Points

Attractive Business Model: The Company’s key strategic advantage that differentiates it from most legacy competitors is its asset light, low capital business model of providing quality services without large investments in owning brick and mortar facilities and a fleet of vehicles. PRSC contracts out with local social services and transportation providers and manages the network through two nationwide operations centers. This model has a number of advantages in providing services to individuals (i.e. lower missed services incidents, a more comfortable setting, better therapeutic care, etc.) and lower costs to the state and government payers. This model also has destructive appeal by giving the Company a price advantage relative to institutional based legacy type vendors. PRSC can offer its services at a more attractive value proposition and still accrue attractive returns. Management claims that for the cost of treating a single patient in an institutional setting, the Company can provide care to six beneficiaries. These economic factors are driving the shift in the market in favor of providing home and community services versus large institutional settings such as psychiatric hospitals, group homes and residential treatment centers. In the ongoing budget debate inWashington centered on reducing health care spending this model has significant appeal.

This model also affords PRSC a degree of financial flexibility to manage its social services margins by adjusting its professional staff’s daily workload and the time spent with clients during the day. Thus, the Company should be able to manage its margins around modest changes in reimbursement rates. The Company’s business model also has appeal in that it is highly scalable, yields a high return on tangible capital and has excellent cash flow dynamics. Excluding goodwill, PRSC’s return on tangible invested capital is in excess of 40%. Noteworthy, PRSC is capable of responding to opportunities to significant grow its business and deliver its services in a relatively short time frame without the need for significant capital investment and positions PRSC on the right side of the cost issue.

Meaningful Entry Barriers and Growing Scale Benefits: In the social services business PRSC appears to offer among the broadest portfolio of services. However, some competitors may be larger in certain sub-sectors (i.e. foster care). The established relationships that the company has built with many local and non-profit social services organizations that recommend PRSC to local government agencies as a provider of high quality services to low income individuals provides some entry barriers that would take time for a competitor to overcome.

In the NEMT business, the Company’s LogistiCare subsidiary is by far the largest player in the market. Smaller/regional competitors have tried to enter the business with limited success, but have caused some pricing pressure on new bids. LogistiCare’s current operations in 15 states via a centralized operations center model provide significant scale benefits and a competitive barrier. As one of the important elements in the bidding process for NEMT contracts is the need to demonstrate the ability to execute these services, this gives PRSC an experience advantage in the biding process. In addition, discussions with some state officials suggest that the incumbent has a distinct advantage in re-bid situations. The company’s competitive advantage is one reason why LogistiCare currently has contracts with 15 of the 17 states that outsource their NEMT management needs and behind the Company’s very impressive record in winning most re-bids on existing state awards. Noteworthy, one competitor who had won a state award inMissourifrom the company in late 2010 was just replaced and the business returned to LogistiCare after this competitor indicated to the State that it could not fulfill the contract at the price it bid and requested a 35% price increase.

Significant Short & Longer Term Growth Opportunities: PRSC’s social services business is currently a modest low-to-mid single digit growth business. Near term growth will be driven by favorable demographic trends, an expansion of services to a larger percentage of individuals eligible for Medicaid and the recently enacted laws mandating that states begin to transition their social services from institutional-based settings to less expensive home and community-based services. However, in the future the Company should benefit from an expansion in Medicaid under the current ObamaCare legislation. Beginning in 2014 and progressing through 2019, the eligibility level to receive Medicaid benefits will be lowered to 133% of the poverty level. Estimates from independent sources, such as the Kaiser Family Foundation, suggest that this will add about 16 million eligible individuals to the program. This represents a significant expansion in the program relative to the current Medicaid enrollment of about 59.5 million people.  

Contrasting the social services business, the Company’s NEMT business has the potential for significant near-term growth. As providing transportation services is mandated under Medicaid matching funds guidelines, many states have recognized they can reduce costs and relieve a major administration burden placed on its staff by outsourcing this function to NEMT administrators. In discussions with officials from a number of states who have already made this transition or contemplating such a move, the feedback is that the cost of outsourcing this service is more than made up by: freeing up a declining administration staff (many times a different group in every country/region of a state) to work on more strategic items, avoiding more costly alternatives (i.e. ambulances and taxi vouchers), reducing significant fraud/abuse and having the required data to increase the level of matching funds received under the program from the federal government.

Currently, 17 states have begun to outsource their NEMT operations management services and many of these states expanded this service from pilot or regional programs to cover broader geographies. Noteworthy, there are a number of new state awards where there is either a RFP currently outstanding or one pending. The most significant of these is an RFP from the State ofNew Yorkfor coverage of the five boroughs ofNew York City. This award is projected to be the single largest NEMT award issued to date. While the award may take the form of an administration services contract (where only the net fees flow through the income statement), my understanding is the equivalent size of the award could be as much as $200 million per year award, and should begin early next year. In addition, five other states (Alabama,Maine,North Carolina,OregonandMinnesota) either have RFP’s outstanding or will do so shortly. Combined, these five awards should total about $130-$150 million annually in size. While it is likely that some states may split their awards, LogistiCare’s history of success in winning previous awards positions the Company to be a major beneficiary of this significant wave of new state NEMT awards likely to be announced in the next few months. Moreover, given the current annualized revenue base of about $563 million for PRSC’s NEMT business, winning a fair share of these awards will likely translate into significant growth over the next 2-3 years. For example, by my estimates just winning the New York City award outright could add about $0.40-$0.50 per share in earning power to PRSC’s bottom line (or about a 25%-30% increase to my 2012 estimate) over the next few years. In the current weak economic environment, finding companies with the ability to drive that kind of growth in earnings power is rare. Moreover, as I will discuss shortly, the market has not priced any of this growth into the share price.

Management; Knowledgeable, Shareholder Friendly & Good Capital Allocators: PRSC’s management team, headed by Chairman & CEO Fletcher McCusker, appears to be knowledgeable, shareholder friendly and good allocators of capital. Mr. McCusker, who already had solid executive experience in the social & mental health services industry, founded PRSC in 1996. He had the vision of taking advantage of what he believed was the beginning of a long term trend in providing services to individuals in home-based settings. From its early beginnings inArizona, the Company rapidly expanded by acquiring and consolidating a number of health care providers nationwide. A review of about a dozen acquisitions the Company made in the social services area during the formative years of the Company in the 1997-2005 period shows a healthy return on the capital used to fund these acquisitions during this period. PRSC invested about $50 million of capital during this time to acquire these companies as the basis in creating its national footprint. These investments, coupled with organic growth, were the first step in transitioning the Company’s business model from a breakeven EBITDA level to annual run rate in excess of $18 million. The second transformation was the LogistiCare acquisition in December 2008. While the price paid and timing could be criticized, the financial benefits of the acquisition have proven to be significant to date and may be even more beneficial in the future. With a purchase price of $220 million, Logisticare has been instrumental in increasing corporate EBITDA from about $30 million to a level in the mid-to-upper $60 million range in the last few years.

Since the acquisition of LogistiCare, management has been using its healthy cash flow mostly to reduce its debt. Over the last two years debt has been reduced by about 25%, the debt/equity ratio has come down from over 5x to under 2x while the EBITDA/interest coverage ratio has increased from about 2.5x to about 5.0x. As a result of this improvement, the Company successfully re-negotiated its debt earlier this year with more favorable terms. Currently, management has stated that it plans to use its cash flow to: repay debt, repurchase stock or make small targeted acquisitions. While management has discussed its interest in looking at acquisitions where it can leverage the advantages of its model relative to legacy competitors in such areas as home health care and mental health services for veterans, they have stated that acquisition prices (on what they believe are peak trailing earnings) still appear too high. As a result, the Company will likely continue to focus on debt reduction. However, we would not be surprised to see a modest stock buyback program instituted. I would view both of these options as a good use of cash and in the best interests of shareholders.

Financial Model Illustrates Growth and Potential Upside: The following table highlights my financial model for the company, including 2011/12 estimates.

Providence Services Corporation

Operating Model

 

 

 

 

 

 

 

2008A

2009A

2010A

2011E

2012E

Social Services Revenues

310,564

340,738

341,921

361,685

370,282

Transportation Revenues

381,107

460,275

537,777

585,047

614,299

  Total Revenues

691,671

801,013

879,697

946,732

984,581

 

 

 

 

 

 

Social Services Gross Profit

56,912

65,612

52,769

60,797

61,238

%

18.3%

19.3%

15.4%

16.8%

16.5%

Transportation Gross Profit

24,835

44,975

63,647

41,054

51,833

%

6.5%

9.8%

11.8%

7.0%

8.4%

  Total Gross Profit

81,747

110,587

116,416

101,851

113,071

%

11.8%

13.8%

13.2%

10.8%

11.5%

 

 

 

 

 

 

G&A

48,412

44,010

46,460

49,254

50,412

D&A

12,721

12,853

12,652

13,421

13,763

 

 

 

 

 

 

EBITDA

33,335

66,577

69,955

52,597

62,659

%

4.8%

8.3%

8.0%

5.6%

6.4%

Operating Income

20,614

53,724

57,303

39,176

48,896

%

3.0%

6.7%

6.5%

4.1%

5.0%

 

 

 

 

 

 

Special Charges

(169,930)

0

0

0

0

Interest, net

(18,600)

(20,432)

(16,012)

(10,256)

(8,604)

 

 

 

 

 

 

Pretax Income

(167,916)

33,292

41,292

26,456

40,292

Taxes

(12,310)

12,166

17,665

11,127

18,333

%

-

36.5%

42.8%

42.1%

45.5%

Net Income

(155,606)

21,126

23,627

15,329

21,959

 

 

 

 

 

 

Shares Out. (basic)

12,562

13,130

13,194

13,240

13,326

EPS

($12.39)

$1.61

$1.79

$1.16

$1.65

 

 

 

 

 

 

Divisional Data:

 

 

 

 

 

Social Services EBITDA

(45,442)

30,708

16,315

21,866

21,621

%

-14.6%

9.0%

4.8%

6.0%

5.8%

Social Services Op. Profit

(50,976)

24,265

10,121

15,059

14,727

%

-16.4%

7.1%

3.0%

4.2%

4.0%

 

 

 

 

 

 

Transportation EBITDA

(91,188)

35,869

53,820

30,731

41,039

%

-23.9%

7.8%

10.0%

5.3%

6.7%

Transportation Op. Profit

(98,375)

29,460

47,182

24,117

34,169

%

-25.8%

6.4%

8.8%

4.1%

5.6%

Relative to my estimates and the financial outlook, the following points are noteworthy:

  • Management provides quarterly and yearly guidance based on the level of signed awards. My model for 2011 is consistent with management’s guidance and street consensus. Management has not provided guidance for 2012 and my model is modestly above street consensus. I think there is a strong likelihood consensus will move up on the current book of business and more so if they win additional NEMT awards.
  • The company recently announced that just about all their social services contracts have been renewed in the current government fiscal year and they have completed a cycle where most of their largest transportation contracts from a number of states have been renewed. The return ofMissouriin Q4 FY 2011 should also positively impact transportation business, especially in 2012. My revenue estimates for this division is derived from a disaggregation of each state award and does not assume any additional wins from the states with RFP’s outstanding.
  • A number of new state transportation awards are on the horizon. The largest opportunity is the five boroughs ofNew York City, with an equivalent size award of as much as $200 million. The other state opportunities in 2012 are:Alabama,Maine,North Carolina,OregonandMinnesota. Combined these five state awards total about $130-$150 million. Despite PRSC’s previous success in winning, none of these awards are factored into my forecasts and would provide upside if any are won.
  • While management targets an EBITDA margin of 6.5%-7.0% in both businesses, I am modeling a combined 6.4% figure. In the social services business the company has a fair amount of flexibility to control margins and wants to stay well below the margins of the major home health care providers so as to not draw criticism. In transportation, 2010 was an unusually rich margin year tied to new contract wins, while 2011 was depressed by increased competition on new bids, start-up issues on new contracts and the mis-pricing of there NJ contract (now corrected).
  • Historically cash flow exceeds GAAP earnings by a healthy amount due to such non-cash expenses as reserves for doubtful accounts, amortization expense and stock based compensation. Over the last 5 years cash flow has exceeded net income by an average of 60%. Based on the assumptions discussed above and less contribution from some of the other operating adjustments, my model shows the Company generating FCF of about $30 million in 2012. As this represents somewhat less of a FCF/net income spread than in the past few years, my FCF forecast could prove conservative.

Attractive Valuation on a Number of Measures: The shares appear to have an appealing valuation on a number of different measurements. From a GAAP perspective, the P/E on 2012 EPS is 6.7x. With our model showing the company generating about $30 million in annual FCF in 2012, the FCF/EV yield (adjusted for interest expense) is about 14.4% (or a 7 year payback period).

Two recent private market transactions also suggest the shares of PRSC may be undervalued. In November 2010 Res-Care (RSCR), a competitor in the social services business (who is competitively disadvantaged with lower margins/returns and was having some financial challenges) was acquired by its largest shareholder, a Canadian investment firm Onex Partners. Using Res-Care’s acquisition price of a 5.5-6.0x EV/EBITDA multiple translates into a stock price for PRSC in the low $20 range. While using its EV/FCF multiple of about 11.6x translates into a share price above $27. In February, Clayton, Dubilier & Rice announced it was purchasing Emergency Medical Services (EMS). The American Medical Response (AMR) division ofEMS(about half of revenues) provides Medicaid funded emergency medical and non-emergency transportation services. Reports indicate that while the acquisition price of EMS was about 8x-9x projected EBITDA, the value accorded the AMR division was about 7x EBITDA. Applying this multiple to PRSC yields a stock price of about $26.50. Noteworthy, Onex Partners’ (who acquired Res-Care) 31% interest inEMSgave them proceeds of about $878 million from the transaction.

Looking at the valuation from a different perspective, my analysis illustrates that the Company’s transportation business alone (assuming carrying the full interest burden of the debt) has EPS power of about $1.07 in 2012 (on my forecasts). This represents a P/E on just this business of about 10.3x. This suggests that investors are not really paying anything for PRSC’s social services business.

Reasons Why The Stock is Mis-priced: The two reasons for why I believe the shares are mis-priced are: 1) concerns related to cuts in Medicaid payments or eligibility and 2) the spillover impact of the on-going congressional inquiry in the home health care industry. 

The major issue surrounding the stock is the uncertainty that due to budgetary issues: 1) the federal government will either eliminate one of PRSC’s services (transportation or social services) from the Medicaid program or 2) some of the states will try to reduce Medicare funding or eligibility.

The background for this concern is the events that had a notable impact on the Company’s financials for two quarters in 2008. According to management, after state legislators funded Medicaid programs (the new year begins in June), bureaucrats in a couple of states, reacting to the economic meltdown and budgetary issues, attempted to reduce pre-approved funding to providers like PRSC. Following this event, the ACLU stepped in and sued these states. In December 2008 the federal court ruled that states can opt in or out of funding, but not change a program once instituted, returning the funding back to prior levels.

From my perspective, while this issue does pose some risk, on deeper analysis it appears that some of these issues/risks: may be blown out of proportion, impacted by some investors own personal political ideology and biases, and, to some degree, already priced into the stock. On this point I am reminded of comments from some of the great value investors like Warren Buffet and Howard Marks suggesting that some of the best values are often found in areas that most investors are don’t want to look at. Likewise one of the characteristics that Joel Greenblatt’s Magic Formula attempts to screen for is stocks of high return on capital companies where a lot of the bad news or uncertainty is already priced into the shares. Thus, with Medicaid front and center in the press regarding the current budget negotiations and all the noise surrounding this issue, PRSC fits this profile. 

I submit the following points to consider regarding this issue. Almost all of the Company’s social services contracts have recently been re-newed as were some of the largest state NEMT contracts that were expiring, many with large revenue exposure. Even though states are under budget pressures, they can’t make changes to eligibility or benefits without losing federal matching funds (which no state would risk). Noteworthy is that while there has been a lot of vocal rhetoric on the part of some, a number of state governors (including Republicans) have proposed 2012 budgets that have little or no impact on Medicaid services. Also, investors should not forget that from a big picture perspective the reason that there has been a trend towards both home based care and outsourcing other services is simply that they are more efficient and provide cost tangible savings. In short, outsourcing is part of the solution, not part of the problem. For example, discussions with state officials suggest that they are moving towards outsourcing transportation services because it: provides efficiency benefits compared with non-centralized internal staff and relieves a big headache, saves costs (versus other transportation options like taxis and ambulances) and provides data enabling the state to increase the percent of government matching funds.

From a federal perspective, any changes to Medicaid would need congressional approval to be implemented. Also, any changes to reduce Medicaid benefits would meet strong opposition from public service organizations like the ACLU that in the past have challenged any changes (and won). Getting the current congress to agree to any consensus on an issue as volatile as Medicaid will be extremely challenging. Given all the discussion regarding moves by Congress to lower the budget deficit, it is important to note that there has not been any discussion regarding reducing or eliminating any of PRSC’s social or transportation services from Medicaid. In addition, with congress and the special “Super Committee” of twelve senators not coming to a consensus regarding budget cuts, none of the automatic triggers due to kick in will impact any of the Company’s programs and services. Keep in mind that PRSC’s social and transportation services: 1) constitute such a small part of Medicaid spending that even if eliminated they will not move the needle relative to yielding any meaningful cost savings and 2) provide tangible cost benefits in reducing Medicaid costs relative to prior programs/policies.

The second issue that I believe is having some negative impact of the stock is the ongoing congressional inquiry regarding excess billing practices and high profit margins in the home health care business. Recent press article have put this issue back in the spotlight. Noteworthy, PRSC does not operate in the same business as the public companies that the probe is centered around and its business model is not subject to the same bonus targets that are at issue in the investigation. In addition, PRSC’s profit margins are roughly half of the margins of these companies. Regarding the last point, the Company’s lower margins (and cost structure) provide it an opportunity for it to offer services to this market at a more economical rate, and one that would be attractive to government payers, if it chooses to diversify into this market sector in the future.

Risks:

  • The government eliminates one of the company’s programs from Medicaid: While one can never predict what will come out of Washington, the one thing that would be clear is that even a discussion on such a move would result in significant backlash (as was the case in 2008) and be the subject of many lawsuits that would take years to overcome before being enacted. As previously discussed, the company’s programs are on the right side of the discussion, in that they help take costs out of the Medicaid equation and are part of the solution. Moreover, the valuation of the shares provides a healthy margin of safety and suggests that investors are not fully valuing both of the Company’s businesses.

 

  • The Supreme Court rules ObamaCare unconstitutional: With the Supreme Court deciding to take up the case and decide on the constitutionality of the individual mandate in mid-2012, the outcome will be known soon. While this would remove a source of growth in the future, it would not impact the Company’s current revenue stream in any direct way. In addition, future growth for PRSC would still be aided by favorable demographics, the continuing trend to community & home based services, a greater percent of the Medicaid eligible population using the Company’s services and more states outsourcing their NEMT services. Conversely, should the court declare ObamaCare constitutional, this sets the stage for a large increase in the size of the Medicare eligible population in PRSC’s target market and could fuel an acceleration in growth in the company’s social services business.

 

  • The loss of one or more NEMT state contracts: As previously discussed the company has just about completed a cycle of renewals of state contracts in its transportation services business. As these contracts are normally 3-5 years in duration, this provides some degree of comfort (although each state can rescind them at any time for such issues as poor performance or funding). However, there are three state contracts that are either expiring soon or whose duration has been extended pending renewal. While LogistiCare has enjoyed a pretty successful history of re-signing existing contracts, taken in total they add up to about $47 million, or by my estimates about $0.10-$0.15 per share annually. Conversely, as discussed previously, this risk is offset with the potential upside from theNew York City award (up to an equivalent size of $200 million) and the five RFP’s outstanding from new states adding up to about $130-$150 million annually. Given the company’s historical win rate and the discrepancy in size favoring potential new awards, I think the risk/reward ratio is favorable on this issue.

 

  • Increased competition and pricing pressures in the NEMT business: Recently the company has seen more competitors attempt to enter the NEMT services market and win state awards. To date the company’s LogistiCare division has been relatively successful leveraging its competitive advantages in winning new bids and holding on to existing bids when contracts expire. However, these competitors have reduced the available margin in the business somewhat. With more competitors emerging, it is possible that either margins could be squeezed further or future awards could be divided among more that one company. Conversely, the reversal of theMissouri contract shows that some weaker competitors are already challenged to undercut LogistiCare’s price. In addition, price is only one element on the list of criteria for award selection.

 

  • Start up cost pressures in the NMET business may continue: One of the reasons for a recent modest shortfall in earnings was start-up costs tied to awards in new states. Some new states are requiring in their RFP’s that the service provider open an in-state administration and call center, which pressures the profitability on these contracts in the first quarter or two. Management has stated that the impact of start-up costs from some current new awards will likely spill over into early 2012. However, profitability levels should improve thereafter. Notwithstanding this, it is possible that start up costs continue into mid-2011if the company is successful in winning a couple of the new state NEMT service awards pending. Despite some initial costs, such news would likely result in higher revenue and EPS forecasts and an increase in the Company’s intrinsic value.

 

  • The company’s debt: As discussed previously, the Company has some debt on its balance sheet associated with its acquisition of LogistiCare in 2008. While this leverage may make some value investors uncomfortable, the good news is the progress that management has made in reducing this debt and improving its interest coverage ratios. The Company’s efforts have been rewarded with a restructured loan agreement with improved terms. In addition, management’s plans to use its healthy cash flow to pay down debt should make this less of an issue in the future.

Catalyst

  • New NEMT state awards
  • Increases in future earnings and FCF forecasts
  • Growth in the Medicaid eligible population
  • Continued acquisition activity in the sector
  • Broader investor coverage/recognition
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