Description

Overview

Providence, through its Logisticare subsidiary, is the largest player in the non-emergency medical transportation market (NEMT) – a business that has good visibility (contracts are 2-3 years), strong secular growth trends (Medicare + newly enacted regulation), an asset light brokerage model, and is acyclical. Missed medical appointments cost payors (Medicaid and Managed Care) roughly$150bn providing incentives to provide patient transportation. The system is ripe with fraud so payors rely on brokers like Logisticare to maintain proper credentialing, gatekeeping, and compliance, in addition to managing a nationwide network of transportation providers. Additionally, Providence holds a 46.3% equity interest in Matrix, a provider of home health clinics.

Why Does the Opportunity Exist

Providence is in the final innings of transforming itself from a healthcare holding company to a pure-play provider of NEMT through its Logisticare subsidiary. This has been a (mostly) successful 4-year business transition but several operational and managerial missteps have caused both Logisticare and Matrix to under-earn by a significant magnitude. The situation is somewhat obfuscated due to the 1) the magnitude of portfolio divestitures, 2) the reclassification of the company’s Matrix investment to below the line reporting, which muddies valuation multiples, 3) almost no sell-side coverage (1 firm), and 4) no pure play public comps.

Investment Thesis

Providence is significantly under-earning due to poor performing contracts (at Logisticare) and a poor acquisition (at Matrix). Normalization should occur in 2020 as the company has already secured significant reprieve from customers which should drive EBITDA/EPS from an estimated $47mm/$1.44 in 2019 to $90mm/$3.50 in 2020 (our EBITDA/EPS estimates are 20% and 30% higher than consensus, respectively). Thereafter, we believe secular growth in Medicare and operational improvements can drive 10%+ EBITDA/EPS growth over time. We believe Logisticare alone is worth $100-150/share.

Separately, Matrix is a hidden asset as it is both reported below the line and is generating losses. A nearly fatal acquisition put this asset several years behind in what should have been a full monetization event. We believe management has mostly rectified the situation and a monetization event could come in the next 12-months. On an after-tax basis, we believe Matrix is worth $100-135 million or 10-15% of enterprise value.

Our Key Investment Points are:

1.       Near-term EBITDA margins should expand from 3% in 2019 to a more normalized rate of 6% based on already renegotiated contracts.

2.       Longer-term, EBITDA and EPS could compound at 15% and 20% due to Medicare Advantage growth and further margin optimization.

3.       Matrix is a hidden asset that could be monetized in 12 months.

4.       Valuation is undemanding and a net cash balance sheet provides further optionality.

Brief Company History

Historically, Providence was the holding company for several business lines -- Logisticare, Matrix, and WD Services. Several of these businesses were acquired, which bloated the balance sheet to nearly $600mm of debt and pro-forma EBITDA of $100mm by the end of 2014. In 2015/16, a confluence of events occurred (WD’s largest customer was shrinking 75%) that led the company to change its strategy. Three deal makers were added to the Board – David Coulter, Todd Carter, and Frank Wright. The company divested WD Services and sold a majority stake of Matrix to Frazier Healthcare, a PE Firm. Today, the company has a net cash balance, $80mm of preferred stock (discussed later), and has reduced its share count by 20%. Additionally, the company has gone through several C-level executives to match the requirements the company was facing (ie. balance sheet and portfolio optimization). At one point, Chairman of the Board and largest shareholder Chris Shackelton served as CEO and his brother served as CFO. The aesthetics may draw scrutiny but neither currently serves in an operating role (Chris is still COB, David is no longer with the company). Additionally, the track record both had while in their company roles was quite good. We actually view the prior management history (revolving door and corporate holding structure) as an opportunity as Dan Greenleaf, a true operator, was recently appointed CEO in December 2019 and believe he brings a different skill set than prior managers.

Investment Point #1: Near-term Margins should Double due to Contract Rate Adjustments

Logisticare is estimated to generate a 4% EBITDA margin this year (equating to $60mm of EBITDA before corporate costs) compared to historic margins of 6-8%. We believe the company can earn a 6% EBITDA margin in 2020, equating to $100mm of EBITDA. As a side note, we delineate between Logisticare EBITDA and corporate EBITDA, with the difference being corporate company overhead. Historically, corporate overhead was a separate line-item when PRSC operated as a holding company. Since that structure has been collapsed, corporate SG&A is now reported in the Logisticare segment so adjustments have to be made when looking at the historically segment data. Below is a table for reconciliation.

Source: SEC Filings, Capital IQ, and our estimates.

The majority of the $43mm in incremental 2019-20 profit is coming from in-place contracts that have already been renegotiated to provide Logisticare some reprieve as these contracts are under-performing. To understand why a customer would provide reprieve requires an understanding of the ecosystem and Logisticare’s value proposition.

Logisticare has two types of customers, States and Managed Care Organizations (MCOs).  NEMT providers add several points of value across the system: 1) provide capitated contracts that allow for lower and more predictable costs (since brokers are paid on a per-member-per-month basis, the incentive is to find the least expensive, most efficient, and highest quality transportation modality), 2) create a network by contracting with (at times) thousands of providers, and 3) reduce fraud and abuse in the NEMT system.

Because of bureaucratic requirements, States typically go through lengthy RFP processes. Since these are mostly capitated contracts, NEMT providers are provided data on patient population, utilization, etc… so they may generate an informed proposal. From our understanding, Logisticare typically targets a gross margin level based on the data provided. The company’s average tenure with a State is 11 years and over that timeframe one can imagine how embedded within the system the NEMT broker becomes. Coupled with a bureaucratic RFP process, the switching costs are relatively high. Additionally, Logisticare is the largest NEMT provider by multiples with an estimated 30% share. This is a brokerage model that requires scale in order to compete for a large geographic area. In many cases, the State may not have many options to switch providers. Due to these dynamics, the State and Logisticare have a mutually beneficial relationship.

Therefore, when a customer’s population or utilization deviates materially from what was initially presented, Logisticare can often renegotiate its contract. Over time, this dynamic has worked both ways as Logisticare has adjusted its economics downwards in periods of over-earning.

What makes the situation interesting is that we do not believe there has ever been a period where a confluence of events has caused Logisticare to under-earn on so many contracts at the same exact time. The company has discussed these events on recent earnings calls and has already secured some very significant rate adjustments. For example, on 9/30/19 PRSC filed an 8-K stating they received a $17.7mm rate adjustment for the Q3 period. In addition to that specific contract, we have highlighted below some of the other opportunities the company has highlighted for rate adjustments (all of these are direct quotes from the earnings calls):

·          On the transportation side, we secured $10 million of cost savings related to a reduction in transaction fees imposed by national transportation carriers. (2Q19 Earnings call)

·          In addition, we recently were able to secure price increases on a number of our midsized contracts. In total, these price increases represent approximately $12 million of revenue, which will drop to the bottom line versus the first half of the year. (2Q19 Earnings call)

·          There are a couple of contracts that are suboptimal where we are informing some of those potential customers that they are facing possible termination which would actually improve profitability. (2Q19 Earnings call)

·          we probably have 6 to 8 more contracts that are currently in the pipeline for -- regarding some type of revenue adjustment. (3Q19 Earnings call)

Below we provide a bridge between the 2019 and 2020 EBITDA.

Investment Point #2: Longer-term, EBITDA and EPS could compound at 15% and 20% due to Medicare Advantage growth and further margin optimization.

The opportunity set to support a multi-year period of above average earnings growth is quite robust. We will detail a few of the key drivers below. I think it is important to view them in light of new management relative to the company’s history. Due to distractions at the corporate level, this is a company that took its eye off the ball regarding Logisticare operations. We think Dan Greenleaf was specifically hired with operations as his focus.

There are strong secular drivers that should support 5-10% market growth for the foreseeable future. Logisticare has 30% market share of the core $4.3bn NEMT market. This is a brokerage business where scale provides a competitive advantage. We believe Logisticare should be able to grow in excess of industry growth rates as it is takes market share. This is not a particularly high margin business so the need to leverage a fixed cost infrastructure is tantamount. In periods where Logisticare lost business, it was typically due to a much smaller rival who competed on cost. In several instances, the competitor failed to perform. A well-documented case of this was Veyo and Idaho. Veyo tried to compete on price and technology, failing on both. While the industry is ripe with complaints (and Logisticare has their fair share), this goes to show that it is difficult for an upstart to compete on price and succeed, thus benefiting entrenching scale players like Logisticare.

All-in, we think Logisticare can grow revenues 7%+ annually and reach 8% EBITDA margins in 3-years which puts EBITDA at $150mm and EPS at $6.00. The opportunity set suggests 10% EBITDA margins are possible, which gets EBITDA and EPS close to $200mm and $8.00, respectively. While we are not baking this into our base case scenario it does illustrate the magnitude of the opportunity set.

A large driver of industry growth over the next several years will be due to Medicare Advantage, which currently represents around 7% of the industry today but should grow to 30-50% over time. The growth in this segment is driven by both demographics, a secular shift to Medicare Advantage within that cohort, as well as the Chronic Care Act, which was enacted on January 1, 2020. Prior to this Act, Medicare Advantage companies offered NEMT as a supplemental benefit to attract customers. The Chronic Care Act solidifies the role of NEMT for MA and offers broad definitions of its acceptable use and will make reimbursement much easier.

What is the risk of Uber/Lyft?

We thought it would be appropriate to address the elephant in the room, since Uber/Lyft will likely compete once the Medicare Advantage market heats up. Currently, Uber/Lyft serve as subcontractors to Logisticare mainly on the MA side. When assessing the risk, it’s important to distinguish the Medicaid business from Medicare. Medicaid transportation typically involves patients with mobility/health needs such as wheelchairs, oxygen, mental disorders, that the Uber/Lyft driver/vehicle are ill-equipped to provide. This business also has a fair amount of compliance, regulatory issues, and is call-center based, all facets that we believe do not interest Uber/Lyft. That being said, the Chronic Care Act will open up the market for a population we believe Uber/Lyft would like to serve. At some point, these companies will transition from being solely subcontractors to likely competitors. However, this business still requires significant infrastructure that needs to be built. The total market is roughly $300 million today and is projected to reach $2-4bn so we believe there is plenty of pie to go around.

Call Center Optimization

Logisticare has a large call center footprint that we believe has been neglected for years leading to bloat and inefficiencies. We believe this is the primary focus for new CEO Dan Greanleaf. The company spends roughly $100-200mm on call center costs annually so every 10% reduction has a sizable benefit to a company that we estimate will generate $100mm of EBITDA this year. The company has roughly 3,500 employees across 18 call centers nationally. Our due diligence suggests the company may be able to shave off $50mm of costs over time. We outline the key opportunities for improvement below:

1.       Outsource: the company could save a significant amount by shifting its call centers overseas.

2.       Implement technology: we believe there is a significant opportunity to implement new technology and IVR.

3.       Reduce turnover: approximately 200% employee turnover annually which causes shrinkage (amount of time operators not taking calls) to be abnormally high.

Circulation

Providence acquired Circulation in July 2017 to serve as single, back-end platform across the company. Integrating it proved easier said than down. However, the company originally targeted $25mm of cost savings and still believes it can achieve that. We believe Circulation will be an integral part in reducing call center costs. Customers who are waiting for a ride currently have to call a person to inquire “where is my ride.” The goal is to develop an application with the Circulation technology to answer these questions and reduce volume to the call centers.

The magnitude of cost reductions may seem a little absurd, especially since the company has made little traction on these efforts in the last several years. The key conclusion we reached from our diligence was the opportunity set is real and failure to capture it thus far was primarily due to management distraction. We do not know if or how much new management will succeed in these efforts but we think the odds are favorable given the focal points.

Investment Point #3: Matrix is a hidden asset that could be monetized in 12 months

Providence acquired Matrix in September 2014 for $393 million. Providence’s strategy shifted away from a holding company structure, but it had high hopes for Matrix. In that regard, it decided to outsource the growth initiative to a well-regarded private equity firm, Frazier Healthcare, by selling 53% of the firm and retaining a large portion due to the perceived upside of the firm. We believe the goal was to get the business to a greater scale and then sell it. In February 2018, Matrix (under Frazier’s control) purchased HealthFair for $160mm (PRSC’s ownership was diluted to 46.3%). This should have been the first of several acquisitions to fuel the growth strategy. The acquisition was nothing short of a disaster. To put it in perspective, Healthfair generated $45mm of revenue in 2017 and was acquired for $160mm. In 1H19, the business did $0 in revenue. Providence management believes there was either misrepresentation on the sellers or a complete lack of due diligence from Frazier. To make matters worse, the core business also saw some softness in 1H due to in-sourcing. Either way, the damage has been done, but there is some reason for hope. In Q3, the core business appears to have stabilized and is doing quite. Additionally, management has rightsized the cost structure for Healthfair and this business should go from generating significant losses in 2019 to breakeven in 2020.

Matrix operates at a GAAP net loss due to high amounts of D&A but should generate around $50mm of EBITDA in 2019. We believe EBITDA should grow to $60mm in 2020 as Healthfair costs are gutted and the core business stabilizes. While the value of this asset is held on the books at $154mm, its value is somewhat obscured given the equity method of accounting and net loss position. While Providence does not control the ultimate destiny of Matrix, it does have Board representation and despite being a minority owner, likely has more clout with Frazier given their large mistake. We believe the asset is worth 10-12x EBITDA, or $100-135mm to PRSC on a fully taxed basis (10-15% of enterprise value).  

Valuation

We value PRSC on an EBITDA and EPS basis. There are a couple of caveats to note. First, there are no direct public comps so we look for comparable companies that have similar exposure to high growth Medicare Advantage end markets and asset light business models (EHTH, HNGR, AHCO, and SGRY all have some similar qualities but none are perfect). Second, the company has $77mm of convertible preferred stock that automatically converts at certain parameters. For purposes of our valuation, we assume the preferred stock converts to common and include the share issuance in our valuation (ie. we use 15mm shares outstanding). Third, the company has a net cash balance and is expecting a further $28mm tax refund in Q4. We believe balance sheet optionality adds another layer to the thesis.

Overall, we PRSC at 12x EBITDA and 20x EPS plus the added value to Matrix. While this provides upside to around $90-100/share in the next year, we believe the real value will come beyond that as Logisticare is a prime beneficiary of secular MA growth and margin expansion. If our $150mm EBITDA and $6 EPS estimates in the next 2-3 years are on track, we can foresee the stock being worth $120-150/share.

Risks

1.       Cuts to Medicaid NEMT benefits

2.       New entrants that underbid contracts to steal share

3.       Execution risks as the company implements new technology and outsources its call centers.

Catalyst

1. Strategic plan / 2020 guidance given by new CEO

2. Incremental contract rate adjustments

3. Margin improvement

4. Monetization of Matrix