PRGX Write Up for VIC
PRG Schultz has endured a nearly perfect storm of difficulties – some of their own making and some not. These problems have served to obscure a nifty business selling at a very reasonable valuation. There are several catalysts that could lead to the realization of that value.
Business: PRGX is a worldwide provider of recovery audit services to large and medium-sized businesses that have numerous payment transactions with many vendors. Basically, PRGX goes to a client and mines its payment records to determine if it has been overcharged by vendors for supplies. This is done on a contingency basis; PRGX and the client then split any recovery. This business is especially valuable to the retailing and grocery businesses – any business that purchases on a per item basis across many vendors. Basically, the more complex the purchasing process, the more value PRGX’s services will add.
While about two thirds of PRGX’s business is domestic (of which 78% is retailers and 22% is “commercial”), it is the foreign business that really gives this story long term growth. The growth rate on the domestic business is 5-6% or basically nominal GDP. While a good business (not capital-intensive and high gross-margins) it is no longer the growth business it once was. Almost all the large domestic retailers are using recovery audit services.
However, the foreign business is a different story and the gem of the company. Audit recovery is still a new concept internationally and PRGX is the only company with the scale to pursue this business. The challenge internationally is not to outsell the competition, but to convince clients that their service adds value. Management currently believes that this international business can grow the top line at 15-20% for the next several years. The bottom line growth rate should be significantly higher as the company achieves scale in each of the individual companies in which it operates. Long term, it is this business which could give PRGX the potential for tremendous upside performance.
PRGX also has 50m in revenue contributed by what they call “ancillary businesses.” These include forays made by the previous PRG in an attempt to diversify the business. These businesses involve Meridian which is in the business of getting VAT refunds for foreign business travelers, a telecommunications audit recovery biz, etc. The businesses as a group are marginally profitable and are on the block.
History: This business was basically invented in the early 70s by Howard Schultz. John Cook who had been the CFO of two different department stores (Caldor and Kaufmann’s) came up with the idea of applying technology to the problem. In ’89 he bought Roy Green Associates and renamed it Profit Recovery Group. The CFO Cook had used audit recovery services and saw the opportunity to automate the service using electronic data interchange (EDI) systems. Automation was so successful that Cook was emboldened to drop half his customer base and focus on retailers with sales exceeding $1b. He then proceeded to roll up the industry with mixed results. PRG rolled-up 24 businesses over the course of 12 years culminating in the PRGX-Schultz merger in January of ’02. Schultz, at the time of the merger, was PRGX’s largest competitor. As a result, there are no publicly traded comps and the combined company dominates the domestic retail market. The only competition is Mom & Pops of which the largest has revenues of roughly only $35m.
The Perfect Storm:
Although this business is not new to controversy – it was forced to change its accounting procedures in 2000 – the past year has been a whopper.
• This roll-up had never established the standardized systems or procedures it needed and now PRGX is paying the price. Effectively the Schultz merger – by far the largest - pushed the systems to the breaking point.
• The grocery business (40% of their total) has fallen practically in half. This has been caused by the bankruptcy of Fleming, one of its five largest clients, in April and increased scrutiny of rebates by the SEC. This has led many of PRGX’s grocery clients to be less aggressive in the pursuit of rebates and thus hurt both margins and revenue.
• Management has not been especially shareholder focused for years. John Cook has treated the company as though it were private. He has become very hands-off in his management of PRGX while focusing extensively on charitable pursuits. While this is admirable on one level, it does not serve the shareholder to have his focus drift. He also keeps several relatives employed by the company with six digit salaries and has structured a very cozy lease arrangement with the company for the use of his private plane.
• The environment over the last year has been mediocre for retail. PRGX’s management claims and competitors confirm that their business is effectively levered to the retail sector in a lagged fashion.
Valuation Assumptions – Why it is Cheap
PRGX currently has long term debt of 151mil and 13mil of unrestricted cash. Plus 61.5m shares outstanding at $4.7 gives a market cap of 290m and a TEV = $420m.
My conversations with management, the company’s competition, and looking at historic PRGX margins (pre the aggressive roll-up phase) leads me to believe that 20% EBITDA margins are achievable certainly by ’05.
After a disastrous 3rd quarter, annual revenues are on a current run rate of slightly below $400m. This is down over 15% related to the recent “perfect storm” mentioned above.
Assuming that the revenues begin to stabilize here (which I think is conservative given the temporal nature of some of the recent event driven declines) and then grow only at nominal GDP (6%), and assuming EBITDA margins rebound close to the historic margins of 20%, then EBITDA of 80m is reasonable. Subtract interest expense of $10m and capex of $13m (this is estimated maintenance rate and see below) and then assume a tax rate of 35% and you are left with a FCF # of $37m. Put a 12X multiple on that and this gives you an equity value of $444m or over a 50% premium to current prices. If the international business grows like I think it can and the margins there continue to improve, both my FCF number and the multiple the market will pay for it are way too low.
Why this FCF number is probably very conservative:
First, I think the sustainable revenue number is probably significantly higher than 400m because many of the reasons for revenue collapsing were temporal. Further the international business (almost 1/3 of revenues) should resume its 15 to 20% top line growth.
Second, margins could be even higher. Once fixed costs are covered, 60-70c of every revenue dollar falls directly to the bottom line. This shows the leverage to growth.
Third, the tax rate should be well below 35%. Thie historic actual cash tax rate has been below 20%. Further, PRGX has $36m in NOLs. This asset is complicated by the fact that almost half of it resides in over seas subsidiaries but should still shelter some future earnings.
Risks to this outlook:
The first and worst risk is management. They effectively botched the roll-up of a good business (though they did get blindsided in the last year) and they have not been especially good allocators of capital nor overly shareholder focused. If they continue to do a very poor job on the operating side, the biggest risk is the loss of a great deal of business. This is obviously impossible to nail down. But the reasons PRGX gives for revenue losses in the last year check with customers and competitors.
The best news on this front is that management is in a box from creditors and shareholders. They recently violated the covenants of their bank syndicate and are in the process of renegotiating the terms. Their latitude for shenanigans has been reduced dramatically. They are not going to be able to make any major new acquisitions or even buy back stock until they have improved their balance sheet. As they said on the most recent CC, they are in the penalty box and they know it.
Further, certain large investors are getting impatient. Blum Capital bought out Howard Schultz and his son at prices significantly above today’s and own 15% of the common. Cannell Capital recently filed a 13d with intent to be activist. Between Blum Capital, Berkshire Partners, Wellington, and Franklin Resources, 37% percent of the company is in the hands of a “who’s who” of value managers - at least two of whom have histories of being activist.
Maintenance capex: My assumption for maintenance capex could be low – $13m is the current estimate for ’03 and management believes it to be a good estimate for normalized maintenance capex. However, capex was 25m in ’02 because they moved headquarters and revamped their two major data centers – management believes this to be a one off. ’04 capex is estimated to be 16-20m because of restructuring/streamlining of operations.
Interest Expense: My annual assumption of $10m assumes libor +350 as a rate on the150m of debt. Current interest is libor +250 but is expected to go up a bit due to the renegotiation of their bank syndicate after violation of a debt to EBITDA covenant.
I spent a good deal of time talking to the CEO/owner of one of PRGX’s competitors. While he believes that PRGX has mismanaged the business in several ways to get in their current predicament, he agreed that 20% margins (before capex, interest or taxes) were achievable and were the goal he set for his own business. When this margin potential becomes reality and when the growth characteristics of international business begin to shine through, the stock should easily trade at a multiple of today’s price.
1. Standardization of systems and procedures
2. Potential change in management via Cannell Capital.
3. Potential sale of Meridian or other non-core assets.
4. Normalization of the grocery business and an upswing in retailing
5. Growth of the International business