Description

• Provides mandated services in the lowest-cost manner possible, and therefore has a long history of taking market share from more expensive treatment alternatives.
• Proven ability to manage thin operating margins. This reduces pricing pressure (there is not too much more pricing for the government or competitors to target).
• Poised to benefit from major expansion of Medicaid rolls as a result of Health Care Act (almost 30% increase by 2014), which should drive volume higher if this Act holds.
• Limited fraud risk, as company does not have any role in qualifying beneficiaries.
• An asset-light business model with virtually zero capital needs (for capex or working capital), which maximizes free cash flow and operational flexibility.

I am recommending a long position in PRSC, with 50% upside to my $24 target price within 18 months.  PRSC initially came to my attention via a Magic Formula type screen- it is cheap on any metric (15%+ FCF yield) and generates ROEs above 30%.  PRSC has 2 segments, each of which is primarily reimbursed by Medicaid at the state level: the provision of government-sponsored social services in a home-based setting, and the management of outsourced, government-sponsored, non-emergency transportation.

History

PRSC was formed in 1996, with a vision of providing social services in a low-cost, home-based setting, rather than in psychiatric hospitals and residential treatment centers as was then the norm.  PRSC expanded its business through both organic growth and two dozen small acquisitions (typically very small acquisitions priced <6x EBITDA and immediately accretive) over the next 12 years.  In late 2007, PRSC made by far its largest acquisition.  This created PRSC's 2^nd business segment, the management of outsourced non-emergency transportation services.  PRSC purchased the business for $220mm, and subsequently saw its own stock price decline from above $30 to less than a dollar as PRSC had become a leveraged small-cap in the midst of the credit crisis.  PRSC has largely focused on debt pay-down since that experience and is only now beginning to look again at restarting the acquisition strategy.  M&A will likely focus on smaller acquisitions, with the possibility of PRSC adding a significant third segment to the business.  All acquisitions will be asset-light businesses that fit PRSC's core skills.

Financials

The financials are a bit messy due to the history of acquisitions.  Here are my take-aways:

• Thin operating (EBIT) margins of around 7%.
• D&A, primarily related to the allocation of purchase prices from past acquisitions to specific contracts, exceeds capex by a material amount. D&A appears to be around $13mm, while capex is around $6mm. This spread means that free cash flow exceeds earnings by $7mm or a very material $0.54 per share.  Note that recent capex included a one-time cost for purchase of new HQ building.  Normalized capex is $6mm per year.
• Net working capital is roughly 0 (when excluding cash and short term debt). This is primarily due to the lack of inventory requirements in a service business, and is critical because it means PRSC can grow with virtually no capital investment (capex or working capital). At a segment level, the Non-Emergency Transport segment is working capital negative, which offsets the working capital needs of the Social Services segment.

Street projections for 2011 are for modest revenue growth, along with slightly decreased operating margins (due to lack of rate increases) and flattish EPS.

Social Services Segment Review

This segment primarily provides government-sponsored social services, covering topics including substance abuse, family dysfunction, anger management, parental training, school support, and workforce development.  The services are provided for an average of 5 hours per week, and take place in individual, family and group settings, each located in the homes of the clients.  More intensive services are also provided as needed, including programs that manage sexual deviancy, depression, and domestic violence.  In some of these cases, the alternative to home-based counseling would be institutionalization.

Additionally, PRSC provides foster care training and supervision, and also has a division that provides back-office/admin support for not-for-profit entities.

Through this Social Services segment, PRSC services an average of 60,000 clients each day in 43 states.  Contracts are awarded at the state and local level, but almost all contracts are ultimately reimbursed by Medicaid.  Approximately 70% of revenue in this segment is "fee for service" (typically hourly rates that average around $90), 20% is cost-based, and the remainder is fixed price.  The largest contract is with the state of Virginia, and represents 13% of revenue in this segment.  The home-based nature of the service obviates the need to pay for facilities, thereby making PRSC a low-cost alternative and reducing fixed costs (most employees are paid on salary, but with productivity benchmarks that effectively make employee costs variable).

Competition include:

• Local mom and pops are the primary competition
• Non-profits (United Way, Catholic Social Services, etc)
• ResCare, which was recently purchased by Onex for 12x 2011 earnings or 5.2x EBITDA
• National Mentor, which is focused on the foster care segment
• Mentor Network, which focuses on the developmentally disabled and is owned by Vestar

Non-Emergency Transportation Segment ("NET") Review

This segment provides non-emergency transportation services primarily to Medicaid recipients, and also to Medicare recipients, senior citizens and disabled people.  It is also "asset-light", in that the segment does not own any vehicles and outsources the actual transportation to local cab, van and ambulance companies.  PRSC's role is to process calls, handle billing, supervise the service quality, etc.  In this sense it is essentially a logistics company.  The majority of the transports are standing orders for trips such as dialysis treatment, doctor visits, etc.

Around 90% of the revenue in this segment is generated under "capitated contracts", where PRSC must assume the responsibility to meet the transport needs of a geographic area for the contract duration (in other words, costs are variable but revenue is not, so higher utilization = lower profits).  These contracts typically have price increase/renegotiation triggers to protect PRSC from unprofitable contracts.  There is a high degree of customer concentration in this segment, as the state of Virginia represents 15% of revenue and the next 4 largest contracts represent a collective 31% of revenues.  In total, this segment provides services under 65 contracts in 39 states.

Competition includes:

• American Medical Response (subsidiary of Emergency Medical Services, ticker EMS, trades at 17x 2011 earnings, is partially owned by Onex, and is evaluating strategic alternatives)
• First Transit (subsidiary of UK based FirstGroup)
• Medical Transportation Management (private)
• Coordinated Transportation Solutions (non-profit)
• Numerous local/regional companies.

Historically PRSC has been most successful bidding for larger, statewide contracts that other players have less scale/expertise in servicing.

Attractions

• Excellent free cash conversion (limited capex, limited working capital) and "hidden" free cash flow as D&A exceeds capex.
• Low-cost provider business model bodes well for long-term ability to compete and take market share in a more cost-focused environment.
• Medicaid rolls set to expand 27% by 2013 (from 55 million to 70 million) as a result of Health Care Act. In fact, states may opt-in early (Connecticut has done so), providing a tailwind in 2012.
• Several potential catalysts, including:
• o   Refinancing and partial paydown of debt (could result in $0.25 boost to EPS and FCF per share).
• o   Acquisitions seem to be available at attractive prices and PRSC has the balance sheet to take advantage.
• Great operating track record of growing market share and avoiding loss of major contracts (with exception of recent Missouri contract loss in Non-Emergency Transport segment).
• Diversification of business across 2 segments provides some protection.

Risks/Issues

• Lapsing of stimulus money throughout 2011, and broad-based, serious budgetary pressures could result in a tough operating environment in near to medium term. But consider the following:
•      PRSC's status as the low cost provider should allow it to take market share and may expand the outsourced portion of the market. I cannot find definitive data regarding the percentage of the market that is already provided in a home-based setting, but there clearly remains a large portion of the market (likely the majority) which provides services in a facility such as a group home or a psychiatric hospital. In fact, the Health Care Act mandates that states attempt to provide services in low-cost, home-based settings whenever possible.Operating in 43 states, PRSC is somewhat protected by diversification.
•      Since the federal government reimburses Medicaid expenses to the state level, states are not free to cut services as they choose and are held to federal standards, which protect the beneficiaries. States could potentially pull out of Medicaid, but with 5 to 1 federal matching funds (or much better in some states), it does not appear rational to do so.
•      The bottom line is that Congress could implement new entitlement guidelines that are adverse to PRSC, but I would not bet on that as being likely anytime soon. Considering that the Health Care Act as it now stands results in almost a 30% increase in beneficiaries, and considering that the market is shifting toward the home-based provision of services, the question really is how much will PRSC benefit, not if they will benefit. This is the major disconnect with the current valuation.
• What happened in 2008 and could it repeat? In 2008, states simply stopped referring new Medicaid recipients to PRSC or anyone else, and many states also delayed payments. This, combined with the significantly higher leverage on the company, caused the stock to tank. This could absolutely happen again in another financial crisis, but the impact will likely be less pronounced due to reduced financial leverage.
• Loss of major contract. In particular, the Transportation segment is relatively concentrated with 40% of segment revenues from top 5 contracts. This is a real risk, and could result in reduced profitability due to the loss of a major contract with an approximate contribution margin of 9%. For example, the loss of a 10% segment customer (if that customer were paying average rates) would therefore result in reduced EBITDA of $4-5mm. This risk is somewhat mitigated by the pipeline of new contracts up for bid and PRSC's strong history of contract renewals.
• Slim operating margins increase business risks. I do believe that margins face modest downward pressure, because although rate decreases are unlikely, rate increases are hard to underwrite and there will be some expense creep. But consider the following:
•      The slim margins are somewhat protective against competitive entries and government pressure. In many ways, this investment would be more troubling if the business generated 20% operating margins and we were waiting for the other shoe to drop.
•      The slim margins do mean that PRSC needs to carefully manage its operating expenses. But this is actually quite simple given the nature of the business, and PRSC has done so historically:
•            Employee expenses primarily consist of salary. Employees have productivity requirements, meaning that this expense is essentially variable. Raises are only given when rates increase, and employees (social workers) have limited employment options (none of which are high-paying). Turnover is very low at only 15% annually, as employees also enjoy the flexible work hours that PRSC provides and other opportunities in the field do not.
•            Benefits expenses do grow, but employees do not receive family coverage and must pay towards benefit costs.
•            Rent expense (at 350 leased field offices, typically located in inexpensive strip malls) does grow, but PRSC can and does relocate as necessary.
• Fraud risk. The risk of fraud here should be much less than many other providers of medical services to the government, as PRSC does no marketing or qualifying (individuals are referred to PRSC by government caseworkers).
• Management. I am not overly impressed with the CFO, and note that he has been with PRSC since the beginning when it held a single contract. It should also be noted that the management team has limited stock ownership and in fact has ongoing 10b5 trading plans. But the founder and CEO Fletcher McCusker seems strong, has an enviable track record of growth and profitability, and is clearly focused on the attractive asset-light business model.

Valuation

• $15.75 stock price x 12.905525mm shares = $203mm equity market cap
• PRSC has been somewhat aggressive in issuing options to employees, but it appears to be spread well throughout the company. Currently, there are 1.42mm options outstanding with a WAEP of $22.04 and an average duration of 6.2 years. The total intrinsic value at 12/31/09, at a common price of $15.80, was only $2.2mm. As such, these options are immaterial to the current valuation and I did not adjust for them.
• $192mm total debt less $65mm cash = $128mm net debt (9/30/10)
• $332mm enterprise value
• On 2010 consensus numbers, and adjusting for one-time capex spend on new HQ in 2010 (normalized capex is $6mm per year), this results in the following valuation multiples:
• o 4.7x EBITDA
• o 5.1x EBITDA less Capex
• o 15% free cash flow yield to equity
• o 9x P/E multiple
• o I expect PRSC to refinance its debt in the near to medium term, which all else equal would decrease the P/E multiple to below 8x and increase the FCF yield to 17% (assuming 0.25 per share benefit)

Historically PRSC has traded at much higher multiples, but that is not particularly relevant given the current regulatory dynamic.

Conclusion

Catalyst