Description

As a result of a number of issues that arose in 2013, Performant wasn’t much of a performer.  The stock is currently trading near all-time lows due to very negative sentiment and weak 2014 earnings expectations which were recently confirmed by management on PFMT’s fourth quarter 2013 earnings conference call.  In addition, some of the confidence that investors had in the stock has been shaken by the numerous regulatory and budgetary surprises that occurred over the course of the last year.  While these issues, and their impact on earnings, are real, we do not believe that PFMT’s earnings power is permanently impaired.  Over the course of 2014 most of the issues that have impacted the stock should resolve at which point we think that PFMT will be back on track to generating $80-$90mln in EBITDA and $0.90-$1.00 in EPS in the 2016 – 2017 time frame which should put the stock in the $11-$14 range in a year or so.

What does PFMT do?

PFMT is a defaulted asset and improper payment recovery contractor.  PFMT operates for the most part in the student lending and healthcare industries.  Its clients in the student lending industry are the Department of Education (“DOE”) and 11 of the 31 guaranty agencies (“GA”) which are the public sector participants in the student lending industry.  On the healthcare side, PFMT is one of four companies that contracts with The Centers for Medicare & Medicaid Services (“CMS”) to recover improper Medicare payments and has begun to contract with private payers in the healthcare industry improper payment recovery as well.  Finally, PFMT generates some revenues from the Department of the Treasury as well as other state and local taxing authorities.  I’ve included a portion of the PFMT business description from the 2012 10-K below with my own emphasis added.  The 10-K does a pretty good job of explaining exactly what the company does, how it does it and who it does it for.

We provide technology-enabled recovery and related analytics services in the United States. Our services help identify and recover delinquent or defaulted assets and improper payments for both government and private clients in a broad range of markets. Our clients typically operate in complex and regulated environments and outsource their recovery needs in order to reduce losses on billions of dollars of defaulted student loans, improper healthcare payments and delinquent state tax and federal treasury receivables. We generally provide our services on an outsourced basis, where we handle many or all aspects of our clients’ recovery processes.

We utilize our technology platform to efficiently provide recovery and analytics services in the markets we serve. We have continuously developed and refined our technology platform for almost two decades by using our extensive domain and data processing expertise. Our technology platform allows us to disaggregate otherwise complex recovery processes into a series of simple, efficient and consistent component steps, which we refer to as workflows, for our recovery and healthcare claims review specialists. This approach enables us to continuously refine our recovery processes to achieve higher rates of recovery with greater efficiency. By optimizing what traditionally have been manually-intensive processes, we believe we achieve higher workforce productivity versus more traditional labor-intensive outsourcing business models. For example, we generated in excess of $150,000 of revenues per employee during 2012, based on the average number of employees during the year.

We believe that our platform is easily adaptable to new markets and processes. Over the past several years, we have successfully extended our platform into additional markets with significant recovery opportunities. For example, we utilized the same basic platform previously used primarily for student loan recovery activities to enter the healthcare market. We have enhanced our platform through investment in new data and analytics capabilities, which we believe will enable us to provide additional services such as services relating to the detection of fraud, waste and abuse.

Our revenue model is generally success-based as we earn fees based on a percentage of the aggregate amount of funds that we enable our clients to recover. Our services do not require any significant upfront investments by our clients and we offer our clients the opportunity to recover significant funds otherwise lost. Because our model is based upon the success of our efforts and the dollars we enable for our clients to recover, our business objectives are aligned with those of our clients and we are generally not reliant on their spending budgets. Further, our business model does not require significant capital expenditures and we do not purchase loans or obligations.

1. Guaranty Agency Fee Reductions.  As part of the Murray-Ryan Budget Deal that passed last December, the government has significantly reduced the loan rehabilitation fees payable to the GA’s effective July 1, 2014.  This will have a negative $5-$15mln impact on PFMT’s 2014 revenue and EBITDA.  Note that this is the estimated impact of the change in GA fees for a half-year period so the impact could be twice as high in 2015 unless mitigated.  From the Student Loan Overview section of the Budget:  “Under the Administration’s proposal, the maximum collection fee that guaranty agencies may charge borrowers to rehabilitate their defaulted FFEL loans would be reduced from 18.5 percent of the outstanding principal and interest owed on the loan at the time of sale to 16.0 percent; and, guaranty agencies would be required to return 100 percent--rather than 81.5 percent--of the Federal default reinsurance payment they received from the Federal Government when the borrower of the rehabilitated loan originally defaulted on the loan. In addition, guaranty agencies would be required to transfer rehabilitated loans to the Department if they are unable to find a FFEL lender to purchase the loan.”
2. RAC Contract Re-compete.  PFMT is one of four primary Medicare Recovery Audit Contractors (“RAC” or “RACs”).  Revenues from the RAC program represent around 26% of PFMT’s revenue so it is a very important program for PFMT.  The current RAC contract is set to expire on June 1, 2014, however, CMS has decided to set Feb 21, 2014 as the last day that a RAC may submit Additional Documentation Requests (“ADRs”) to providers under the current contract.  ADRs are the raw material of the RAC revenue generation process (revenue from an ADR typically flows in between one and three quarters after submission of the ADR) and thus the inability to submit ADR’s means that PFMT will no longer be able to generate revenue from the RAC program until the new contract is awarded.  The timing of the new contract award is uncertain as multiple protests related to the terms of the new contract have been filed and the GAO has up to 100 days to review the protests which, if all 100 days are taken, would put a decision in the late Q1 early Q2 timeframe assuming there are no additional protests.  In any event, there will be a big hole in PFMT’s healthcare revenue in 2014.  Having said that the company issued earnings guidance two days ago with full knowledge of this situation so this issue should already be largely reflected in PFMT’s current share price.
3. The Two-Midnights Rule and Short-Stay Audits.  On Aug 2, 2013, CMS, as part of the 2014 Medicare Inpatient Prospective Payment System issued something called the “Two-Midnights Rule” which basically modifies and clarifies CMS’s position on what may be billed under Medicare Part A and B.  From the CMS website:  “Under this final rule, surgical procedures, diagnostic tests and other treatments (in addition to services designated as inpatient-only), are generally appropriate for inpatient hospital admission and payment under Medicare Part A when (1) the physician expects the beneficiary to require a stay that crosses at least two midnights and (2) admits the beneficiary to the hospital based upon that expectation. This policy responds to both hospital calls for more guidance about when a beneficiary is appropriately treated—and paid by Medicare—as an inpatient, and beneficiaries’ concerns about increasingly long stays as outpatients due to hospital uncertainties about payment.”  As a result of this new rule and in an effort to allow providers a period of time to understand how the new rule works, a moratorium on short-stay audits that lasts until Oct 1, 2014 was put into place.  As short-stay audits have been a significant source of revenues for the RACs, this moratorium will also negatively impact 2014’s numbers.  This issue is also factored into the guidance that was issued two days ago.
4. Indefinite Moratorium on Periodic Interim Payment (“PIP”) provider Audits.  CMS reimburses PIP providers through different processes and due to this, CMS had been working on a technology solution for the last couple of years to allow for the automated processing of PIP audits.  CMS finally resolved the technology solution late in mid-June 2013.  This allowed PFMT to recognize $3mln of revenue from PIP provider audits in 2Q13.  However, CMS subsequently put into place an indefinite moratorium on PIP provider audits so PFMT as well as the other RACs are no longer able to audit PIP providers until further notice.  This impacts PFMT disproportionately as PIP providers account for approximately 30% of the Medicare spend in PFMT’s region
5. Miscellaneous Issues.  70% of 2% ADR limitation, inability to submit ADRs last July, rumors of highly competitive bidding on the new RAC contract, continual delays in the timing of a new RAC contract award, DOE contract award extension.  These issues have been out for months and are fully reflected in the share price.

The Opportunity

As discussed below, we think that most if not all of the issues discussed above are not only already reflected PFMT’s share price but they are temporary transitional issues that will largely dissipate upon the award of a new RAC contract.  In addition, the core positive aspects to the PFMT thesis like growing student loan defaults, massive Medicare improper spending TAM, largely untapped private payer contracting opportunity, and low capital intensity business model still exist.

1. GA Fee Reduction Issue.  The company has already guided to a $5-$15mln negative impact to 2014 revenue and a 100% flow-through resulting in a similar impact to 2014 EBITDA so this issue should already be reflected in the stock price.  The implementation of income-based repayment (“IBR”) should significantly mitigate the impact of this issue going forward.  As an example, when the DOE implemented IBR on their rehabilitations, they reduced the fees paid to PFMT by 18%.  According to the company, this fee reduction has been more than offset by the volume enhancement created by IBR.
2. RAC Contract Re-compete Issue.  This issue will be resolved with the award of the new RAC contracts which should happen at some point in 2014.  There are risks however:  1) PFMT could lose the RAC contract entirely – we believe this is highly unlikely as they are an incumbent that has demonstrated success under the current contract; 2) there could be a fee reduction in the new contract – we are assuming a 20% reduction in fees under the new contract which should be mitigated by the fact that they will no longer have a subcontractor in their region, their region is expanding in terms of Medicare spend under the new contract, and it is likely that short-stay and PIP provider audits will return under the new contract.
3. The Two-Midnight Rule and Short-Stay Audits.  While it is possible that the short-stay audit moratorium is extended beyond Oct 1, 2014, we think it is reasonable to assume that one year is a fair amount of time for the providers to adjust to the new rule.  Even if the moratorium is extended, as discussed on the 4Q13 earnings call, we think that the company has been successful in finding other finding other areas of payment errors to audit and that they are well on their way to replacing short-stay audit revenues.
4. PIP Provider Audits.  PFMT has essentially earned no revenues from PIP provider audits so the ability to do so represents only upside.  Since CMS has gone through the trouble of developing the technology to automate the processing of such audits, we find it hard to believe that PIP provider audits will not be part of the new RAC contract and given that they represent such a large percentage of the spending in PFMT’s region this could represent a significant tailwind to the company going forward.
5. Large Core Market TAM.  Student loan defaults continue to rise as evidenced by the three-year cohort default rate approaching 15% which means continued growth in PFMT’s student loan business.   PFMT’s region has an estimated $24bln of improper payments which is a huge addressable market and Medicare spending is predicted to grow at a 6% rate for the rest of the decade so this TAM should continue to increase.
6. PFMT is Starting to Tap the Private Payer Opportunity.  As discussed on the 4Q13 earnings call, PFMT has signed agreements with four of the six largest health care payers in the U.S. who spend approximately $1.7bln annually on payment integrity and other auditing work.  The company is guiding to $5-$15mln in revenue from these new contracts in 2014 so it is pretty small at this point.  This represents a significant opportunity as every share point equals $17mln of revenue from these four payers.

Upside

We don’t see why PFMT can’t get back to 2013 revenue and EBITDA levels by 2016 and grow from there especially when accounting for PIP provider audits and the removal of PRGX as a subcontractor.  If you assume $250mln in revenue in 2016 at a 34% EBITDA margin (PFMT put up a 35% EBITDA margin in 2013) that puts EBITDA at $85mln (just below the reported 2013 number).  Applying a 9x one-year forward multiple (average of 8-10x) to that EBITDA number puts the EV at $765mln in 2015.  Add in $82mln of cash and take out $133mln of debt and conservatively give the company zero credit for FCF generation between now and then (even though the company generated between $40-$50mln in FCF in 2013, depending on how you want to calculate it) and the equity should be valued at around $715mln which would put the stock at around $14.25 in around a year from now assuming 50mln shares outstanding.  That is nearly a double in a year.  Discount that valuation by 25% to be conservative and you still have a stock at around $11 in a year or so vs $7.91 as of Feb 28, 2014.

Risks

• 2014 guidance could be too high.
• The new RAC contract award may be delayed into 2015.
• PFMT could lose the RAC contract.  This would be very bad for the stock but we think it is unlikely.
• PFMT could lose the DOE contract.  This would be very bad for the stock but we think it is unlikely.
• The RAC program could be dissolved.  Since it has been such a success at saving the government money we think that this is unlikely.
• The profitability of the new RAC contract could be less than expected.  We are assuming in our number a 20% reduction in the fee paid to PFMT.
• There could be other negative elements to the new RAC contract that make it unattractive.   For example, the new contracts are believed to contain a provision that requires the RACs to wait until the second level of appeal is exhausted before they receive their contingency fee.
• The American Hospital Association (“AHA”) has proven to be a formidable opponent.  They could continue to apply pressure to CMS and force more significant changes to the RAC program like changing from a contingency fee structure to a fixed fee.
• PFMT could be under-reserved for appeals liabilities.  The AHA estimates that the total value of hospital claims on appeal is around $1.5bln.  Assuming that PFMT has around 15% of this amount (25% less adjustments for their subcontractor as well as unaudited PIP providers) which implies $225mln of appeals.  Assuming a 70% success rate (not sure if this is right but it is the highest, i.e. most conservative, number I could find) would mean that $158mln multiplied by PFMT’s historical contingency fee of around 11.35% would put the claw back at around $17.9mln vs current reserves of around $15.3mln.  Assuming a 25% share and a 70% success rate results in a claw back of around $30mln.
• The GA fee reductions could result is a larger impact to revenues and earnings than is currently expected.
• The stock is likely dead money until the new contract is awarded.
• The stock may never get a good multiple due to the constant unpredictability of CMS.

Catalyst