Paincare Holdings PRZ
October 19, 2005 - 9:51pm EST by
2005 2006
Price: 3.37 EPS
Shares Out. (in M): 0 P/E
Market Cap (in $M): 208 P/FCF
Net Debt (in $M): 0 EBIT 0 0

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Paincare Holdings acquires and manages orthopedic pain management practices. The company is growing organic revenue and operating income in the upper teens and is trading at 14x my estimate of year-end 2005 run-rate earnings of roughly $0.24 and 10x my estimate of year-end 2006 run-rate earnings of roughly $0.33. Management's full-year 2005 guidance is for $14M in net income which should generate between 22c to 24c depending on share count. All numbers are fully diluted and fully taxed. The stock has dropped considerably but with no change in business fundamentals. However, near-term as the company meets earnings targets (as it has consistently so far) and over the next year as it begins to show evidence of generating meaningfully internal cash, I believe the stock will trade to 15 times my '06 run-rate of 33c, or $4.95 per share and 50% above current levels.

PRZ brings up comparisons to medical practice roll-ups such as Orthodontic Centers. However, PRZ practices do not have capitated contracts with HMO's and corporate management does not try to drive the bottom line via cost cutting that causes friction with the doctors at the practices they buy. Instead, PRZ allows the doctors to manage the practice much as they did prior to the acquisition while building the practice bigger instead of leaner. In particular, PRZ seeks to purchase practices that can be expanded via the addition of a doctor(s) and/or ancillary services such as their proprietary physical therapy units. (Their proprietary PT equipment, to which they have exclusive use, was developed by the person who created Nautilus weight machines.)

The oft-stated concern that managing doctors is like herding cats is legitimate. However, even if this does become an issue I strongly believe it will not be for at least three or so years. This is because doctors receive their acquisition payout over a three-year period and it includes earnout kickers. I think as long as the vast majority of doctors are in the earnout phase and that their earnout includes stock (which it does), that they are very likely to make sure the entire enterprise succeeds.

Management has significant experience in managing health care businesses including roll-ups (see 10K) and I believe that it shows in terms of the consistency that they have delivered on their promises over the past two years. However, I cannot vouch for the details of their employment histories. Though I have not spoken with the CFO in a while he is generally accessible and management is interested in telling their story to institutions.

Since 2000, management has completed 27 acquisitions including 22 orthopedic practices (only three occurred prior to 2003) and 5 orthopedic surgical centers. In addition they have established 63 physical therapy units. (They have more PT units than practices because in addition to creating these units for their own practices they create them for none non-PRZ practices, too.) Practice acquisitions are made at a fixed 5x EBITDA and paid half at closing and the remaining half is paid out in three equal installments. Each payment is made half in cash and half in stock. (Surgical centers are one-off deals and do not follow the model.)

Management has shown their ability to grow practice level EBITDA by approximately one third within two years of buying a practice. (In Q2, same practice sales were up 18%; same practice operating income was up 21%.) However, in the third year after an acquisition management estimates growth will come down to the 10% range. Exact mature practice same store sales are yet to be determined, but I would not be surprised if it is a bit below 10%. At this time, however, same practice sales are strong due to the heavy weighting towards newly acquired practices. Management's stated plan is to acquire six practices a year. I believe that could increase at some point.

Acquisitions have been funded via a combination of convertible debt, equity and now a $30M credit facility (was $25M, recently upped to $30M). As of the end of Q2 the company has liabilities of $26.2M ($10.5 of convertible debt, $13.6M drawn on credit facility, $2.1M in acquisition payables) and cash of $12.3M. Market cap with the stock at $3.30 and 61.8M diluted shares = $204.M.

Some investors are put off by the difficulty in forecasting revenue, share count and cash needs given all the acquisitions and earnouts. I don't blame them. However, let me attempt a brief sketch.

First, 2005 pro forma run rate income w/ explanations below:

Revenue, 1H pro forma, from Q2 10Q: 32.7
Mulitiply by two to get FY pro forma 65.4

Add half year of same practice sales
increase of 18% (9% of above total) in
order to forward it all to end of '05 5.9

Add revenue purchased since end of Q2 16.6

Equals run-rate revenue exiting 2005 87.9

Operating income at 36% margin 31.6
Interest 3.8
EBT 27.8
Tax at 37.6% 10.5
NI before MI 17.4
Minority interest of 4% 0.7
Net income 16.7

Diluted EPS $0.24

Fully diluted shares 68.5

EBIT 31.6
Depreciation & Amortization 2.0
Minority interest (0.7)
Run rate EBITDA 32.9

Net income 16.7
Depreciation & Amortization 2.0
Capex (2.0)
Run rate free cash 16.7

Actual capex has been light at $560K for 1H '05 and $1M for all of '04. Purchased practices come with the necessary equipment. I upped it to $2M to be safe.

Notes: Q2 actual op margin was 37%, I'm arbitrarily a point lower. Minority interest appears due to the fact that the prior ownership of acquired surgical centers maintains partial interest; this is not apply to regular practices. Tax rate at actual Q2. Depreciation and amortization running at roughly 2.25% of income; that's arbitrary, but I stuck with it. They are paying some of the convertible debt interest with shares, not cash. That would add slightly to free cash.

See below on how I have drawn down the revolver to $28.7. But if drawn to $28.7 then FY interest at current rate of 10.58% = $3.0M. Converts yield 7.5% x $10M in converts = $0.8. Total interest $3.8. However, it is unlikely that the company would need to draw the credit line down this far exiting '05 due to current cash position nor in '06 due to timing of acquisitions. I just stuck all cash needs to the credit facility for ease and conservativism.

Diluted shares:

Shares basic end of Q2: 51.6
Convert debt 6.0
Vested & non-vested options and
warrants using trsry method 7.6
2H'05 earnout shares for
historical acquisitions 0.5
2H '05 new acquisition shares 2.7
Shares diluted and end of '05 68.5

All options/warrants converted to be conservative.


Draw on credit facility as of Q2 13.6

Cash pymts for 2H'05 acquisitions 13.1

Paydown of acquistion payable on 2.2
Q2 balance sheet

2H earnout payments for historical
acquisition 2.2

Cash generated in 2H (2.3)
(same as 1H?)

For simplicity, if all above
required cash was drawn from credit
facilty this draws down facility to: 28.7

Cash on balance sheet same as Q2: 12.2

Enterprise Value:

Market cap 204.0
Credit facility 28.7
One year notes owed for 2H '05
Surgery center acquisitions 9.1
Cash 12.2
Enterprise Value 229.6

Note: Two 2H '05 acquisitions were surgery centers with a total of 9.1M in one-year notes payable. Recall surgery centers are one off deals that do not follow the regular 5x ebitda purchase price model.

Enterprise Value 229.6
Pro forma 2005 run rate EBITDA 33.0
EV to proforma EBITDA 7.0

Pro-forma free cash flow 16.6
FCF yield to equity 7.2%

That's a rough hewn model for what I believe the business looks like exiting 2005. Some of my estimates are imprecise.

To get an end of 2006 run-rate number I took the numbers above and moved the income statement forward a year with 18% same practice sales. I assumed an additional $20M in revenue run rate of practices purchased. (In '05 they purchased $24.6M in revenue, but this included some higher revenue surgery centers.) I add in all the new shares for acquisitions, historical earnouts. I believe that between cash on the balance sheet and cash generated over the year they should be able to cover their acquisition and earnout related cash needs, pay off the one-year notes and stay within their credit facility as it is. I'm going to defer working through the 2006 calculations as the further we get from the present the less reliable it is. However, my numbers show something on the order of run-rate revenue of $123M, net income of $24.4, $0.33 per diluted share in run rate eps, diluted shares of 71.5M, EBITDA of $46M and debt declining by the amount of the one-year notes and EV / EBITDA something on the order of 5.3. However, that's a long way off and remember it is end-of-year run-rate not actual.

I hope my numbers are conservative as I have them paying doing less '06 acquisitions than they may actual do, paying more interest than they probably will and have fully exercised all options and warrants.

Risks include an uprising among doctors at purchased practices, accounting questions given all the moving parts. I don't think their Board of Directors is a very strong one and as such are not likely to be good controls over the CEO and CFO.


Now: Meeting Q3 earnings and demonstrating that company is on track to meet full-year income goals.

Next year: Demonstrating that the model works by generating meaningful amounts of internal cash.
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