Description

PRGX  (Long, $3.86)

Investment Thesis

• Earnings temporarily depressed due to a) exit of healthcare business; b) other extraordinary transformation/ severance expenses; c) ramp-up expenses associated with Adjacent Services division; d) forex impact

• At current EV of c. $82 million, business trades at a 40% discount to my estimate of private market value (assuming business treads water from a revenue standpoint)

• Debt-free balance sheet, c. $20 million in cash at 6/30/15

• Repurchasing stock at aggressive pace:  share count reduced c. 10.7% in last 12 months

• Management and Board have bought 191,000 shares in open market in past 12 months ($4.03 to $5.31)

• 2 small cap activists involved

• Sizeable NOLs: $72 - $87 million state and federal (some 382 limitations)

• Risks:  melting ice cube?  Core retail business shrinking, primarily due to lack of pricing power; aggressive stock comp for executive team; some customer concentration

Cigar butt, anyone?

PRGX is a recovery audit vendor serving major retailers worldwide.  For the uninitiated, “recovery audit” is a mature industry that primarily helps large retailers retroactively identify payment errors throughout the supply chain.  Think complex vendor rebate arrangements; audit of shipping costs; audit of one-off contract stipulations; simple duplicate payments; etc.  PRGX is the only pure-play public company in the space; major competitors include Connolly Consulting and Apex Analytics.

My investment thesis is simple.  This is a mature, mediocre business that made a mistake by diworsifying into healthcare about 10 years ago.  Seduced by the allure of the Medicare RAC program (a national recovery audit program designed to identify erroneous Medicare payments to hospitals and physicians), PRGX a) lost its role as a primary contractor in Medicare RAC; b) struggled through a subcontracting role in Medicare RAC program, as providers successfully lobbied against the program, muting its impact; and c) simultaneously failed to scale its commercial payor healthcare business.  In 1Q15, PRGX unsurprisingly announced plans to exit the entire healthcare vertical.

Under the leadership of (relatively new) CEO Ron Stewart, the company is re-focusing its efforts on core retail audit recovery efforts in the US and abroad, while attempting to expand its Adjacent Services division (10K description:  “Our Adjacent Services business targets client functional and process areas where we have established expertise, enabling us to provide services to finance and procurement executives to improve working capital, optimize purchasing leverage in vendor pricing negotiations, improve insight into product margin and true cost of goods for resale, identify and manage risks associated with vendor compliance, improve quality of vendor master data and improve visibility and diagnostics of direct and indirect spend.”).

Fundamentally, PRGX is a small, sluggish business trading at a depressed valuation as the company exits underperforming lines of service.   My thesis is that the stock will re-rate as the noise from the healthcare exit and non-healthcare “transformation” (I hate that word in financial reports…) expenses diminish, and adjacent services moves to breakeven.   One could legitimately question PRGX’s continued status as a public company; while I’m certainly not counting on it, it would not surprise me at all to see it taken private via acquisition or on its own.

The Noise

At first glance, PRGX’s results are ugly.   Although the company has generated positive free cash flow every year since 2011, revenues and A/R are on a downward trajectory; in 2014, the company generated -2.3 million of operating income.  

But the thesis here is that the stock will re-rate over the next 12 – 18 months if management simply treads water, holds the line on further revenue declines, and waits for the dust to settle as transition expenses fall by the wayside.   To arrive at a normalized number for EBITDA, my key assumption is that any growth in transaction volume on the topline is offset by pricing pressure in the core business.   Essentially, I’m assuming that the business runs in place from a top-line standpoint (if they do better, great).   Using FY2014 EBITDA ($5.4 million) as a baseline, I adjust for

a) removal of the healthcare division’s drag: +$4.8mm;

b) removal of Adjacent Services “transformation” drag:  +$4.1mm;

c) removal of forex headwind: +$2.0mm.

Adding back D&A, without resorting to heroic assumptions, I come up with a “normalized” EBITDA of $16 million.  Note that the company reported $5.6 million of “adjusted EBITDA” in 1Q15 – but I think most VIC readers would agree that the company’s add-back of stock compensation expense inflates this number by $2 million.  Nevertheless, after deducting stock comp, in 2Q15 I view the company as performing in line with my thesis.  While revenues declined year over year (again, the headline is worse than reality), gross margins, EBIT, and EBITDA all improved as the aforementioned healthcare and “transformation” (read downsizing/ severance) drag began to burn off.  For the year, I’m assuming $5 to $6 million of capex ($1.1 million actual capex in 2Q15; management has guided to 3 – 4% of revenues).

Capital Allocation

Management views the stock as “ridiculously cheap” (their words); accordingly, they have reduced the outstanding share count in aggressive fashion (there is no dividend, and there has been no M&A under Stewart).  At 6/30/14, the company had 29.73 million diluted shares outstanding.  One year later, at 6/30/15, the count was reduced to 26.55 million shares—a 10.7% reduction in 12 months.  As noted in the introduction/ summary, management has purchased about 190,000 shares in the open market at prices ranging from $4.03 to $5.31 over the past 12 months.  CEO Ron Stewart bought shares as recently as September, 2015.  

With $20 million of cash ($14.2 million net of refund liabilities) and a valid repurchase program in place ($7.2 million remaining), it would not surprise me to see cash move toward $10 million (net of refund liabilities) as the company continues buybacks in the wake of the stock’s weakness this quarter.

Shareholder Base

PRGX’s second largest shareholder is small cap activist Becker, Drapkin; the company’s third largest shareholder is also an activist, Headlands Capital / HCSF.   On a diluted basis, each holds about 6.5% of the company.  The top 5 is rounded out by Ameriprise, Renaissance, and Zuckerman Investment Group.  

Balance Sheet

PRGX had c. $20 million in cash at 6/30/15, with no debt.  The company maintains a $20 million (undrawn) line of credit with SunTrust.  Note that the company carries refund liabilities of $5.8 million, which I believe are largely associated with its healthcare business; a conservative approach would treat this liability as debt.

Comps & Valuation

The most appropriate comps for PRGX are private companies—namely, Connolly Consulting and Apex Analytics.  Connolly was bought by Advent in in 2012, reportedly relying on $400 million of debt to fund the purchase.  Connolly’s original core business was retail recovery audit, but unlike PRGX, has an established, successful healthcare audit practice.  Connolly subsequently merged with iHealth in 2014, further differentiating it from PRGX.  According to Moody’s, the company had about $450 million of (pro forma) revenue in mid-2014.  I believe the retail portion is roughly similar in size to PRGX’s retail business.

Apex Analytics, a more direct comp, is much smaller than Connolly—again, information is scarce, but I believe Apex is well under $100 million in revenue.  Carousel Capital bought the company in 2014.

Recovery audit companies--- Charlie Munger’s reservations not withstanding—are consistently valued on a multiple of EBITDA in the private market.  As a quick sidebar related to D&A, I note that PRGX’s 2014 10-K identifies $3.1 million of amortization for customer relationships—a non-economic cost.  

Summing up, I would discount PRGX to the implied double-digit multiples of the transactions above.  At 8X normalized EBITDA of $16 million (calculated above), a reflection of the shrinking topline, offset somewhat by the cash generation of the business and state and federal NOLs of $72 - $87 million ($15 million limited by 382), the company would be valued at about $125 million.  This is about 43% higher than today, conservatively holding the share count flat and treating refund liabilities as debt.

Alternatively, utilizing an EBITDA- mcx method, while holding capex at $5-6 million, if the company achieved a $125 million enterprise valuation under my assumptions, we would arrive at a multiple of ~12X.

Risks

• Melting ice cube?  The obvious risk is a continued spiral in revenue and EBITDA.  The downward revenue and A/R  trajectory is ugly, but keep in mind that the healthcare business thrived as recently as 2012 – 2013, which accounts for a big chunk of the decline.  Adjusted for the healthcare exit, foreign exchange, and the divestiture of a small consulting business in Chicago, 1H15 revenues declined 2.5% year over year—so it’s ugly, but not as ugly as it appears at first glance.

The underlying culprits here are 1) lack of pricing power due to the mature nature of the industry, coupled with steady competition from Connolly, Apex and others; and 2) the tendency of sophisticated retailers to learn from audit recovery vendors and ultimately implement the recovery processes themselves.   As one who has followed the industry for 10 years, I view these arguments as valid, but I can vouch for several mitigants.   First, I heard exactly the same arguments for imminent decline / extinction of this industry 10 years ago.  To the extent there is an advantage for the recovery audit vendors, it’s grounded upon accumulation and implementation of best practices after reviewing the payment experience (and errors) of hundreds of clients.  But particularly in light of management’s expectation of continued pricing pressure, to invest in PRGX, one would have to get comfortable that the pricing competition is rational in the industry, and fees have been squeezed to the point that there’s not much left to squeeze.

• Hefty share-based compensation expense.

• Customer concentration:  5 largest clients comprise c. 32% of revenues (none are greater than 10%).

• Majority of cash is held outside US.

• Refund liabilities on balance sheet:  adequately reserved?  

Catalyst

Earnings power shows through as transition expenses burn off.